Propagation of Geopolitical Risks to the Federal Reserve's Policy Toolkit

Abstract

This paper investigates the transmission mechanisms through which geopolitical risk (GPR) shocks affect Federal Reserve (Fed) monetary policy, incorporating both conventional and unconventional policy tools. It introduces a structural model – the Macro-Monetary Geopolitical Risk (MM-GPR) model – that integrates New Keynesian features, such as nominal frictions and rational expectations. The findings indicate that GPR significantly impacts the economy, prompting corresponding responses from the Fed. Heightened geopolitical uncertainty leads to rising inflation, suppressing real economic activity by reducing consumption and investment, while increasing unemployment. Two monetary policy experiments simulate the Fed's expansionary and contractionary responses under GPR surges and reliefs. The results reveal that, whether GPR rises or subsides, the optimal monetary policy for the Fed remains expansionary. These findings offer crucial guidance for policy-makers in navigating monetary policy amid geopolitical uncertainty. This paper contributes to both theoretical and empirical macroeconomic and monetary policy modelling by incorporating GPR shocks into the monetary policy framework, addressing a key gap in existing structural models by including unconventional policy tools.