In other words, the central bank, responding to a variety of political pressures and weaknesses, may stray away from even the constrained optimal – towards third best policies rather than second best policies. Second, cross-border capital flows can lead to a more dramatic transmission of policies, driven by agency (and other) considerations that do not necessarily relate to economic conditions in the recipient countries.
One argument along these lines is that if some large country adopts unconventional and highly accommodative sub optimal policies, other countries may follow suit to avoid exchange rate appreciation in a world with weak demand. 17 As a result, the policy equilibrium may establish at rates that are too low compared to that warranted by the global optimal.