Assignment - MBAFT 6203

Impact of Global Value Chains on effectiveness of Monetary Policies

Tushar Singhal | 257

• Globalization and resulting GVCs affect macro outcomes through:

o Exchange Rate Pass through

The exchange rate pass through is weaker in GVCs relative to completely domestic production due to
changes in the cost of intermediary and factor inputs. Large and import-intensive firms have weaker
exchange rate pass through since they naturally hedge through import prices and change profit margins
instead of changing export prices.

o Exchange Rate of Elasticity of exports

elasticity of real manufacturing exports to the Real Effective Exchange Rate (REER) has decreased over
time. We then examine whether the formation of supply chains has affected this elasticity using different
measures of GVC integration. The countries that are more tightly integrated in a country’s supply chain
experience a much stronger flattening of the relationship between REER growth and export growth in
comparison to those that are more loosely integrated. As countries are more integrated in global
production processes, a currency depreciation only improves competitiveness of a fraction of the value of
final good exports.

o Transmission of cross border shocks

The relationship between trade intensity and business cycle synchronization depends on substitutability
between traded goods. Global value chains imply larger trade in complements, hence stronger co-
movement between business cycles of production sharing countries.

• Globalization and resulting GVCs affect the transmission of monetary policy via 4 channels: Exchange Rate
competitiveness, interest rate and credit channel which impacts investments and domestic asset price which
impacts balance sheets and ultimately investment potential. These can be classified into 3 major categories:
impact via three channels: via aggregate demand, via financial channel and an exchange-rate competitiveness
channel
 o The aggregate demand channel is focused on changes in import demand. A contractionary monetary
policy will lead to a rise in the domestic interest rates, leading to a decrease in the domestic
investment, consumption and overall production. This will further lead to a fall in import demand, and
will be a negative demand shock for the rest of the world and lead to contraction in the trading partner
economy.
o The financial channel is based on the effect of the exchange rate on the local-currency valuation of
foreign-currency denominated assets and liabilities. Let’s suppose a country, that is a net borrower
on international financial markets in US dollars will experience a negative wealth effect when US
monetary policy is tightened. Given the dominance of the US dollar in global financial markets,
spillovers from US monetary policy through this channel may be particularly sizeable. This channel is
especially important for emerging and developing economies, as these rely more on foreign-currency
funding
o The traditional exchange rate channel of monetary policy spillovers operates through changes in the
relative prices of domestic and foreign goods. A monetary policy tightening generally causes the
exchange rate to appreciate. To the extent that the relative prices of domestic and foreign goods are
affected by the exchange rate appreciation, a monetary policy tightening at home elicits expenditure
switching at home and abroad. Expenditure switching under the exchange rate channel of monetary
policy spillovers thus rotates demand at home and abroad, but where and in which direction the
rotation takes place depends on a string of factors. If export prices are sticky in domestic currency, an
exchange rate appreciation makes domestic goods less competitive in world markets, shifting
expenditure abroad and at home away from domestic goods. In contrast, if export prices are sticky in
a foreign currency, the relative price of imports and domestically produced goods in terms of the
currency of the importer is not affected by the exchange rate appreciation and exchange rate pass-
through is incomplete. In this case, monetary policy spillovers through expenditure switching are
muted.
• GVCs deepen economic relations among countries. Instead of selling final products individually and competi
ng for the same customers, countries are increasingly interrelated across rigid linkages in production. This gl
obal interdependence signifies that one country's policies and economic conditions influence its trading part
ners and extend to the rest of the world.
• In addition, the actions of national central banks may also have important implications in other countries
through production linkages between domestic and foreign companies:
o Due to the strong interdependence of production systems, policy and central bank decisions are more
likely to have a structural impact and their effectiveness depends on policies in different parts of the
world.
o Decisions by governments and central banks are more likely to have a global impact due to the strong
interdependence of output processes, and their effectiveness depends on policies in various parts of
the world.
o International input – output linkages often create strong price ties, meaning that inflation is more
likely to spillover to its direct and indirect trading partners in a country.