Foreign Relations and the Dollar: Quantifying Geopolitical Risks and Their Effects on Monetary Policy

Abstract

Monetary policy is vital to the stability of the United States, with it being the foundation of maximizing employment and furthering economic growth. It is a function which demands delicate management, with its consequences dissipated to each and every American. In the field of monetary policy, primary variables of study are inflation rates and exchange rates. Typical research correlates these variables to financial market trends, but this paper proposes another factor that shapes US monetary policy – geopolitical risk. Because the US Dollar is a universal currency, I argue that it is important to consider geopolitical risks in relation to monetary policy. My basis for this proposal stems from the trilemma of international finance, which states that a country cannot simultaneously fix an exchange rate, maintain a sovereign monetary policy, and permit free capital flows [3]. Since the United States has a sovereign monetary policy and free capital flows, its exchange rate floats depending on supply and demand. Driven by such market factors, the value of the dollar – to a degree – must be influenced by geopolitical risks, even in cases where they seem to not have an explicit association with the United States. Absent the consideration of geopolitical risks, there lacks some real-world context for changes in monetary policy; in this paper, I aim to utilize time series analyses and autoregressions to quantify relationships between geopolitical risk and monetary policy. After normalization of datasets, both variables stay relatively linear, allowing for the analysis of currency valuation, inflation, and geopolitical risks through the examination of past historical values. Through the development of a training model, I provide a prediction of monetary policy variables and geopolitical risk, analyze its accuracy, and identify the optimal metric to forecast monetary policy and geopolitical risks over various time horizons. This topic is particularly relevant today; throughout the course of the COVID - 19 pandemic, more than $5.2 trillion in fiscal relief has been introduced by the United States. Inflation, most reflected by the consumer price index year over year growth, was at 7.9% in February of 2022 – the highest since 1982 (even surpassing inflation rates during the 2008 Global Financial Crisis). Changes in monetary policy to address this issue have the potential to affect both the floating value of the dollar and geopolitical risks that arise from fiscal-related tensions. Geopolitical risks are also at the forefront of discussion in society today. With the Russian invasion of Ukraine and the immediate sanctions imposed on Russia from both the European Union and the United States, quantifying the effects of geopolitical risk on monetary policy variables provides a unique lens that can be insightful for future direction in policy. Other risks to consider include the termination of the Afghanistan War and trade tensions with China, both of which have implications for US monetary policy that have yet to be seen.