bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

298 MONETARY ECONOMICS
degree of international capital mobility, and country size. Depending on the
assumptions made, spillovers from domestic macroeconomic policy may be
positive or negative. The importance of spillovers became clearer, however,
with the recognition of price spillovers operating through the terms of
trade linkage (Hamada, 1976). This plainly meant the end of arguments that
a country could fully insulate itself from events and policies in the rest of
the world. Even with perfectly flexible exchange rates, the terms of trade
transmission works.
Pause for thought 10.8:
What do the terms of trade describe?
Cooper (1969) examined the impact of spillovers on domestic policy
using a simple model with fixed exchange rates and constant prices. He
argued that the greater is the degree of interdependence (and the stronger are
spillovers), the less will be the effectiveness of policies in non-cooperating
economies. Greater interdependence, in other words, leads to either worse
results from domestic policies and longer periods away from equilibrium, or
greater costs to restore targets to their desired values.
In Canzoneri and Gray’s (1985) model, the governments of two identical
countries both attempt to achieve full employment output without
increasing inflation. Both countries are subject to supply shocks. The paper
is concerned with the monetary transmission mechanism, specifically with
the impact of an expansion of the money supply in each country. Canzoneri
and Gray consider three possibilities:
(a) beggar-thy-neighbour in which monetary expansion in one economy
has a negative effect on output in the other economy
(b) locomotive in which the spillover effects are positive and
(c) asymmetric in which monetary spillovers have different signs, the
result depending on the size of the exchange rate and interest rate
changes following the domestic monetary expansion as well as the
import content of the foreign price index. The outcome is an empirical
question, depending on the structure of the economies involved.
It has been shown that it is possible both for an instrument’s spillovers
to change signs over time and for an instrument to have impacts of different
signs depending on the target at which it is aimed.
Specific conclusions of theoretical models must, however, be treated
with caution since many depend on the sign or relative size of particular