Global Spillovers in a Low Interest Rate Environment
Summary and Keywords
Global policy spillovers can be defined as the effect of policy changes in one country on economic outcomes in other countries. The literature has mainly focused on monetary policy interdependencies and has identified three channels through which policy spillovers can materialize. The first is the expenditure-shifting channel—a monetary expansion in one country depreciates its currency, making its goods cheaper relative to those in other countries and shifting global demand toward domestic tradable goods. The second is the expenditure-changing channel—expansionary monetary policy in one country raises both domestic and foreign expenditure. The third is the financial spillovers channel—expansionary monetary policy in one country eases financial conditions in other economies. The literature generally finds that the net transmission effect is positive but small. However, estimated spillovers vary widely across countries and over time. In the aftermath of the Great Recession, the policy debate has devoted special attention to the possibility that the magnitude and sign of international spillovers might have changed in an environment of low interest rates worldwide, as the expenditure-shifting channel becomes more relevant when the effective lower bound reduces the effectiveness of conventional monetary policies.
Assessing size and sign of international monetary policy spillovers has been a contentious and recurrent issue in international macroeconomic theory and policy, against the backdrop of the evergreen debates on exchange rate regimes and policy coordination. Their relevance has been rekindled by recent developments since the global financial crisis, which forced monetary policymakers in several economies to lower policy rates to zero, or even negative territory, for an extended period of time. Such an expansionary stance of monetary policy prompted volatility in global capital flows and affected currency pricing and financial conditions worldwide, raising renewed concerns about the welfare implications of spillovers onto both emerging and advanced economies in an environment of low interest rates.
A large body of contributions studying policy spillovers at least since the development of the textbook Mundell-Fleming-Dornbusch paradigm have highlighted several broad channels of transmission through which the monetary policy actions of a country can affect the global economy. While the ultimate effect of spillovers depends on the policy responses in all countries under consideration—as we discuss below—it is useful to start our analysis by considering the effects of policy actions in one country while keeping the policy stance abroad unchanged.
The first is the expenditure-shifting, or exchange rate channel. To understand this channel, consider two economies: Home and Foreign. Suppose Home undertakes a monetary expansion relative to Foreign and lowers its policy interest rate relative to Foreign. This leads to a depreciation of the domestic currency, which in turn boosts the competitiveness of domestic traded goods and services in global markets. The relatively lower price of Home output and its favorable terms of trade reallocate demand from Foreign to Home: Exports to the Home country become more expensive; imports from the Home country become cheaper. If global demand can be visualized as a pie, the expenditure-shifting effect of a Home monetary expansion makes the Foreign slice of the pie smaller.
The second channel has been termed the expenditure-changing, or global demand channel. When the Home economy adopts an expansionary monetary policy, the resulting boost to domestic incomes and expenditures has also the effect of raising Home demand for imports of traded goods from the Foreign country. Thus, contrary to the exchange rate channel, the global demand channel raises expenditure both domestically and abroad and is potentially expansionary not only for the Home country but for the Foreign country as well. If global demand can be visualized as a pie, the expenditure-changing effect of a Home monetary expansion makes the size of the whole pie larger. Depending on the relative size of the Home economy, this may result in an overall increase in the size of the Foreign slice despite the expenditure shifting due to the exchange rate channel.
Obstfeld and Rogoff (1995) and several others have argued that a key determinant of the relative strengths of the aforementioned channels is the trade elasticity between Home and Foreign goods. In particular, if Home and Foreign goods are substitutes, then the expenditure-shifting channel tends to dominate; the opposite is true if they are complements.
While textbook analyses of monetary interdependence focus almost exclusively on the two aforementioned channels, recent research has emphasized the implications of increased market globalization, uncovering a third channel through which financial spillovers can operate. The strength of this third channel depends on the degree of imperfection in financial markets—both domestic and international. In terms of the Home-Foreign framework, a monetary expansion in the Home country affects financial conditions both domestically and abroad through its multi-faceted impact on different asset classes. Home stimulus lowers domestic longer-term yields. Capital flows out of the Home country into financially interconnected economies. In the Foreign country credit expands, lowering yields and borrowing costs, and raising other asset prices such as equity. This third channel has the potential to reinforce or offset the two other channels. The most likely scenario is one in which financial spillovers translate into correlated movements in credit supply and borrowing costs across countries. In terms of international transmission of the Home monetary policy shock, these co-movements in global financial conditions and asset prices have similar implications, on balance, as the expenditure-changing demand channel. When a country with a large economy such as the United States eases monetary policy, this relaxes financial conditions in the rest of the world, stimulating economic activity; the flipside is that a monetary contraction can cause credit to dry up. Importantly, the financial channel can interact with the two aforementioned channels and affect their relative strength over time. For example, Akinci and Queralto (2018) find that monetary policy spillovers are larger when the degree of currency mismatch in the external debt positions of domestic agents is large.
When considering the financial spillovers channel, it is important to realize that domestic monetary policy can exert influence on outcomes other than the short-run level of economic activity in the rest of the world. In particular, if looser monetary policy at Home generates buoyant financial conditions abroad, this may be problematic from a financial stability standpoint even if it boosts economic activity in the short run. For example, Bruno and Shin (2012) show that expansionary monetary policy in advanced economies can encourage increased risk-taking by global financial institutions, affecting leverage of global banks, capital flows, and credit growth in the international financial system. As Rey (2013) and others have highlighted, such global financial cycles can result in asset price bubbles and lending booms in emerging markets, increasing the probability of financial instability in the global economy. A frequently mentioned example of financial spillovers is the so-called taper tantrum of 2013, when—in anticipation of the removal of accommodative policies in the United States—global markets overreacted, leading to a spike in Treasury yields and a surge in market volatility. The incident also led to a tightening of financial conditions in emerging markets due to a sharp slowdown in cross-border bank lending (Avdjiev & Takáts, 2014; Ahmed et al., 2017).
In sum, and subject to the qualifications above, when the Home country eases its monetary policy stance, the rest of the world gets a smaller slice of a bigger pie. If the new slice is smaller than the initial slice, there are negative spillovers to the rest of the world. If the new slice is bigger than the initial slice, there are positive spillovers to the rest of the world. The signs of these effects flip in case of a Home monetary tightening.
Quantitative Evaluation of Spillovers
A representative example of recent research that evaluates the quantitative importance of these three channels is a study by Ammer, De Pooter, Erceg, and Kamin (2016). The authors use a DSGE model to examine the global effects of a monetary easing sufficient to lower 10-year U.S. Treasury yields by 25 basis points. According to their estimates, the exchange rate channel lowers the dollar by about 1% over a two to three-year horizon, boosts U.S. net exports by 0.15% of GDP, and lowers foreign GDP by about 0.05%. The domestic demand channel raises domestic demand by 0.5%, and raises U.S. imports by 0.15% of GDP and foreign GDP by about 0.05%. Finally, the financial spillovers channel lowers foreign yields by 10 basis points, raising foreign GDP by about 0.25%.
So, are the international spillovers of U.S. monetary policy positive or negative? As the exchange rate channel lowers foreign GDP about 0.05% and the domestic demand channel raises foreign GDP about 0.05%, these two channels substantially offset each other. The tie-breaker is the financial spillovers channel: This raises foreign GDP by about 0.25%. In conclusion, financial spillovers dominate, and the international transmission of monetary policy is positive. But the overall effect is not very large.
As a first approximation, the conclusion that U.S. monetary policy spillovers are positive but not very large seems to encapsulate the conventional wisdom in international macroeconomics and provides a rough benchmark to assess other case studies of regional and global spillovers. Many caveats and nuances apply, as size and direction of monetary policy spillovers cannot be boiled down to a single coefficient. Transmission of policy shocks may differ depending on whether monetary stimulus involves conventional or unconventional policy tools, and may change over time. Some evidence reviewed by Almeida, Straub, and Van Robays (2016), for instance, supports the view that the response of exchange rate and trade balances to U.S. monetary shocks has increased over time. In a similar vein, Ilzetzki and Jin (2013) find that the effects of U.S. monetary (and fiscal) shocks on the rest of the world may have changed signs after 1990.
Spillover effects are also likely to differ across recipient countries depending on various country-specific features. In particular, the spillovers among advanced economies are likely to be qualitatively and quantitatively different from the spillovers between advanced and emerging economies. Calvo et al. (1993) find that the pattern of capital flows to emerging markets and hence vulnerability to sudden-stop incidents is driven by factors external to these economies, thus, suggesting that policy actions in advanced economies have a significant bearing on the outcomes in emerging ones. Dedola et al. (2017) find evidence that, while a U.S. monetary policy tightening leads to a contraction in economic activity in both advanced and emerging countries, in emerging markets it has the additional effect of contributing to a deterioration of local financial conditions. By the same token, Chen et al. (2012) find that quantitative easing in the United States led to easing of global financial conditions. This effect was stronger in emerging markets, and the resulting rapid credit growth in these economies led to currency appreciation and inflationary pressures.
Most important, the fact that the sign of the net transmission effects is positive does not imply that policy actions required to smooth the business cycle in the Home country are necessarily good news for the business cycle of its trading partners. In other words, the fact that net monetary spillovers are likely positive does not say much about whether they stabilize or destabilize the global economy. Depending on the asymmetric initial business-cycle positions, monetary policy spillovers may push the rest of the world closer or further away from internal and external balance. Home monetary stimulus can bring the Foreign country closer to its desired level of economic activity if the world economy is hit by common adverse shocks, so that the Home policy response is in the interest of both Home and Foreign. But in the face of asymmetric shocks, different economies will face asymmetric output and inflation gaps at different points in their business cycles, such as underemployment at Home and overheating at Foreign, so that positive policy spillovers may push output and inflation abroad further away from internal balance.
Of course, regardless of the size and sign of spillovers from the Home country, autonomous policymakers in the Foreign economy can generally adjust their own policy stances to keep output and inflation near their targets. In other words, even if Home monetary policy spillovers push the Foreign economy away from equilibrium, other things being equal, independent monetary policy responses under a floating exchange rate regime can help to push the Foreign economy back toward equilibrium. Indeed, measured spillovers might be small precisely because Foreign policymakers intervene to offset the effects of changes in Home policies on their economy. Such interventions by Foreign policymakers are not without cost, and the resulting policy dilemmas and trade-offs can be highly challenging. For instance, an emerging market economy facing imported inflationary pressures may feel the need to hike interest rates, but higher rates would encourage even more capital inflows, creating financial instability.
Spillovers in a Low r* Environment
As mentioned before, the relevance of expenditure-shifting effects relative to other channels may change quite significantly over time and from case to case. Of particular relevance for the assessment of prospective international spillovers over the first half of the 21st century are the implications of a global environment of low interest rates which, as Kiley and Roberts (2017) emphasize, are likely to be a persistent feature in the international monetary system going forward.
As documented in contributions by Laubach and Williams (2003), Holsten et al. (2017), Del Negro et al. (2017), and others, since the mid-2000s nearly all advanced economies have witnessed a significant downward movement in their real natural interest rates, or r*, defined as the hypothetical rates required to balance national saving and investment in a full-employment equilibrium over the longer run. There is a long list of potential factors contributing to lower natural rates, ranging from slow-moving structural and demographic drivers to headwinds from the recent global financial crisis boosting precautionary saving, higher “convenience yields” associated with investors’ preference toward safety and liquidity and lower appetite for risk-taking, as well as increased wealth and income inequality redistributing resources from agents with high propensities to consume to agents with lower ones.
A key implication of lower real natural interest rates is that the benchmark for a neutral stance of monetary policy is also revised downward. In fact, if market short-term interest rates adjusted for inflation fail to move in tandem with r*, monetary policy is bound to be associated with tighter financial conditions and disinflationary pressures. In practice, policy rates in advanced economies have been at or near their zero or effective lower bound (ELB) for extended periods since the financial crisis. In such a setting, providing appropriate monetary policy accommodation and hitting the desired target for inflation has proven to be considerably more challenging than in normal times when the traditional tools of monetary policy stimulus are not constrained by the ELB.
These developments have important implications for the analysis of international spillovers. Going forward, if the projected environment of persistently low natural interest rates is validated empirically, conventional policies are bound to be less efficacious than previously thought in terms of raising domestic demand. Exchange rate depreciations may then be deemed to be a particularly effective channel of monetary policy transmission as they raise foreign demand for domestic products, and national policymakers may be tempted to deliberately weaken their terms of trade as a countercyclical instrument of demand management. Recent research by Caballero et al. (2015) and Eggertsson et al. (2016) has argued that an environment of low interest rates is a breeding ground for currency wars. In this environment characterized by low global demand, each country has a heightened incentive to devalue its currency in order to gain a competitive advantage over its trading partners and divert the scarce global demand toward its goods. The former governor of the Reserve Bank of India, Rajan (2014), has argued that unconventional policies are in the spirit of beggar-thy-neighbor policies. Similarly, former President of Brazil Dilma Rousseff described the loose monetary policy in advanced economies a “monetary tsunami” that caused liquidity to flow into Brazil and other emerging markets, appreciating their currencies and making their exports less competitive.
To be clear, the nature of the different international transmission channels remains substantially unchanged. The point is that in a global ELB environment the expenditure-shifting effects may turn out to be stronger than usual in relative terms, that is, strong enough to dominate the positive spillovers of national monetary stimulus inducing an expansion in demand for world output. And this point remains valid even if the economies are committed to avoiding currency wars. As mentioned before, an expenditure-shifting component at the expense of the trading partners is always associated with domestic monetary accommodation under flexible exchange rates.
What changes in a global ELB regime is the fact that trading partners may be unable to respond to exchange rate shocks and restore cost-competitiveness by easing their policy stances effectively. In addition, expenditure-changing effects and financial spillovers from Home expansion are more muted than normal due to ELB considerations. Thus, it is easy to conclude that in a low interest rate environment, the net sign of the international spillovers can possibly flip. While the above argument is obvious in relation to two symmetric economies of comparable size, there may be additional spillovers between large and small economies. Haberis and Lipinska (2012) find that the inability of monetary policy to stabilize its own economy in a large economy at the ELB creates a spillover that negatively affects the effectiveness of monetary policy in small economies, akin to a cost-push shock.
Building upon the previous considerations, from a global economy perspective there is little hope that a country at the ELB because of adverse country-specific shocks will be able to get out of the quicksand if the rest of the world is also simultaneously stuck in a liquidity trap. As a thought experiment, assume the global economy faces ELB constraints due to adverse shocks and consider the case of a country experiencing a cyclical recovery earlier than others. This country will exhibit relatively better fundamentals than its trading partners. Absent coordination, the country would be expected to run a relatively tighter monetary policy. This would trigger net capital inflows, stronger real exchange rates and tighter financial conditions as market participants respond to “search for yield” opportunities. Contractionary and disinflationary pressures would then deteriorate the country’s medium-term outlook and offset its initial cyclical comparative advantage. The final outcome would be a return to the same (bad) fundamentals prevailing in the rest of the global economy. Similar considerations appear in Eggertsson and Summers (2016) and Eggertsson, Mehrotra, Singh, and Summers (2016).
Revisiting International Coordination
The discussion above hints at how renewed calls for policy coordination may resurface in global liquidity trap environments. Traditionally, gains from coordination are deemed to arise from avoiding beggar-thy-neighbor externalities that monetary policymaking in one country or region can impart onto the rest of the world. A variant of the case for cooperation is that a more favorable and sustainable global allocation could be achieved if policymakers in both advanced and emerging countries were willing to internalize the externalities they impose onto each other instead of acting unilaterally according to domestic mandates.
It has been argued that international policy coordination in a low interest rate environment could help facilitate a faster global recovery. For example, emerging markets with relatively stronger fundamentals could accommodate the deficient demand in advanced economies, allowing advanced economies to borrow policy space from the relatively unconstrained economies. Cook and Devereux (2013) study the optimal conduct of monetary policy in a multi-country environment where one or both countries can be constrained by the ELB. They find that when one of the countries is constrained by the ELB, optimal cooperative monetary policy calls for the unconstrained economy to provide additional accommodation. In other words, international monetary policy coordination can transfer much-needed policy space from constrained to unconstrained economies. Policies such as capital account management could increase this policy space available to advanced economies without negatively impacting the rest of the world, as long as such policies are agreed upon cooperatively (Acharya & Bengui, 2018). On the basis of the recent history of the international monetary system, one can be justifiably skeptical regarding the chances of any systematic attempt to revive a global system of coordinated exchange rate or interest rate policies. But one cannot rule out the possibility that new generations of policymakers may emerge and adapt their views and strategies in light of new realities. For instance, a type of financial spillover related to higher financial market integration operates through changes in regulatory policies. Dedola et al. (2013) find that domestic policies and reforms that stabilize domestic financial conditions may positively affect foreign economies, reducing their desire to implement such policies on their own. This desire to free ride on other countries can delay the global adoption of reforms that guard against financial instability, thus making international policy coordination of paramount importance in such a setting.
The spillovers discussed so far mainly focus on monetary policy, although several qualitative considerations could be extended to fiscal interdependencies (see Corsetti & Pesenti (2001) for a baseline framework accounting for both monetary and fiscal spillovers). Yet, in a low interest rate environment fiscal policy may arguably be the key instrument not only to provide appropriate countercyclical accommodation but also to invert the downward trend for r*. Fiscal responses to cyclical downturns and, possibly, greater reliance on automatic stabilizers could play a role as insurance against future downturns by supporting domestic and global demand while avoiding beggar-thy-neighbor spillovers, thus reducing the probability of hitting or staying at the ELB for a prolonged period of time. In terms of global implications, Auerbach and Gorodnichenko (2013) find that fiscal stimulus in one country is likely to have economically and statistically significant effects on output in other countries. Of course, the size and effect of fiscal spillovers depend crucially on the precise fiscal instrument used.
In a different vein, Fornaro and Romei (2017) argue that financial stability concerns may prompt domestic policymakers to impose macroprudential constraints at home. Such a policy increases each country’s desire to save. Since all countries have similar incentives, these inward looking macroprudential policies result in higher global savings and hence lower global interest rates. Thus, uncoordinated macroprudential policy by a Home country imposes a negative externality on the rest of the world economy making it more susceptible to liquidity traps. Acharya and Bengui (2018) consider a similar setting in the context of a currency union and find that there are gains from cooperation in international macroprudential policies. Bengui (2013) uses an open-economy liquidity-demand model to argue that lack of international cooperation results in an underprovision of macroprudential regulation and may even lead to lower welfare than under a laissez-faire regime.
On a related note, it has been argued that the low interest rates observed globally could reflect a shortage of safe assets. In this case, expansionary fiscal policies and the associated issuance of additional risk-free sovereign debt might be able to satiate global demand for safe assets, thus countering the downward pressure on natural rates. Increasing issuance of safe assets may be neither feasible nor in the interest of the borrowing country. For example, Farhi and Maggiori (2016) argue that a hegemon country able to issue safe assets may find it optimal to curtail its borrowing because a larger stock of debt would affect the price at which it can issue additional bonds and possibly jeopardize market participants’ assessment of that country’s debt as a safe asset, leaving the sovereign borrower vulnerable to external financial market volatility. Gourinchas and Rey (2016) identify similar forces in the European context, arguing that the Eurozone as a whole would benefit from coordinating and issuing debt instead of relying on Germany, France, and Switzerland as providers of safe assets. Such coordination would allow for a more elastic supply of safe assets and at the same time shield individual issuer countries from destabilizing portfolio shifts occurring during periods of high risk. In general, as the tax burden of higher debt issuance or expansionary fiscal policy falls on domestic agents, while benefits are shared by the global economy, this leads to a classic free rider problem. Thus, in the absence of global coordination, all the forces mentioned above would generally result in a restricted use of expansionary fiscal policy.
Prepared for the Oxford Research Encyclopedia of Economics and Finance. The views expressed here do not necessarily reflect the position of the Federal Reserve Bank of New York, the Federal Reserve System, or any other institutions with which the authors are affiliated.
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