IFDP Paper: U.S. Monetary Policy Spillovers to Emerging Markets: Both Shocks and Vulnerabilities Matter(Revised)
2024-10-25 20:00
Federal Reserve Bank
Abstract
This paper examines the spillovers of U.S. monetary policy to emerging markets (EMs). We use a large sample of monthly data from 1990 to 2022 to estimate the effects of U.S. interest rate shocks on EM macroeconomic variables. We find that U.S. monetary policy tightening has a significant negative impact on EM output, inflation, and exchange rates. The effects are stronger in EMs with high levels of external debt, low levels of foreign exchange reserves, and weak institutions. Our results suggest that U.S. monetary policy spillovers can pose significant risks to EM economies, especially those that are more vulnerable.
Introduction
U.S. monetary policy has a significant impact on the global economy. When the Federal Reserve (Fed) raises interest rates, it makes it more expensive for businesses and consumers to borrow money. This can lead to a slowdown in economic growth in the United States and other countries.
Emerging markets (EMs) are particularly vulnerable to U.S. monetary policy spillovers. This is because EMs often have high levels of external debt and low levels of foreign exchange reserves. As a result, they are more likely to experience financial instability when U.S. interest rates rise.
Data and Methodology
We use a large sample of monthly data from 1990 to 2022 to estimate the effects of U.S. interest rate shocks on EM macroeconomic variables. Our sample includes 25 EMs from different regions of the world.
We use a variety of econometric techniques to estimate the effects of U.S. monetary policy shocks. Our main specification is a panel regression model that includes country and time fixed effects. We also use a variety of robustness checks to ensure that our results are not driven by outliers or other factors.
Results
We find that U.S. monetary policy tightening has a significant negative impact on EM output, inflation, and exchange rates. The effects are stronger in EMs with high levels of external debt, low levels of foreign exchange reserves, and weak institutions.
Output
U.S. monetary policy tightening leads to a decline in EM output. The effect is strongest in the short run, but it can persist for several quarters. The decline in output is likely due to the fact that higher U.S. interest rates make it more expensive for businesses and consumers to borrow money. This can lead to a slowdown in investment and consumption.
Inflation
U.S. monetary policy tightening also leads to an increase in EM inflation. The effect is strongest in EMs with high levels of external debt. This is because higher U.S. interest rates make it more expensive for EMs to import goods and services. This can lead to an increase in inflation.
Exchange Rates
U.S. monetary policy tightening leads to a depreciation of EM exchange rates. The effect is strongest in EMs with low levels of foreign exchange reserves. This is because higher U.S. interest rates make it more attractive for investors to hold U.S. dollars. This can lead to a decline in the demand for EM currencies and a depreciation of their exchange rates.
Vulnerabilities
The effects of U.S. monetary policy spillovers are stronger in EMs with high levels of external debt, low levels of foreign exchange reserves, and weak institutions. This is because these EMs are more likely to experience financial instability when U.S. interest rates rise.
High Levels of External Debt
EMs with high levels of external debt are more vulnerable to U.S. monetary policy spillovers because they are more likely to experience a currency crisis when U.S. interest rates rise. This is because higher U.S. interest rates make it more expensive for EMs to repay their external debt.
Low Levels of Foreign Exchange Reserves
EMs with low levels of foreign exchange reserves are more vulnerable to U.S. monetary policy spillovers because they have less
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