The United States does not exist alone in the world economy. US financial markets are influenced by events in other countries, such as the actions of the ECB. Likewise, citizens in Europe are influenced by monetary policy in the United States.
Suppose the ECB cuts interest rates in Europe. As in the United States, the typical mechanism for this would be a purchase of debt issued by European governments. An increase in the price of this debt is equivalent to a decrease in interest rates. If nothing else happens, this decrease in European interest rates gives rise to an arbitrage opportunity. Investors want to move funds to the United States to take advantage of the higher interest rates. There is an increased demand for US assets and hence an increased demand for dollars. Interest rates in the United States decrease, which tends to increase durable goods spending and stimulate the US economy. Against that, the higher value of the dollar leads to fewer exports from the United States and more imports into the United States, so US net exports will decrease.
Completely analogously, monetary policy in the United States influences interest rates in other countries. If the Fed undertakes an open market sale of US government debt, for example, interest rates will increase in other countries as well as in the United States. The US Federal Reserve and the ECB are big players in world financial markets. Their actions move world interest rates and world currency markets. There are other countries that are relatively small in the world economy. For example, suppose the Central Bank of Iceland increases interest rates in that country. The mechanisms that we have explained still apply: investors will find Icelandic assets more attractive, and there will be an increased demand for the Icelandic krona. However, the flows of capital into Iceland will be negligible in terms of the world economy. They will not have any noticeable effect on interest rates in Europe or the United States.
KEY TAKEAWAY
In an open economy, interest rate changes induced by monetary policy influence exchange rates and thus net exports.
Actions by monetary authorities in other countries influence the net exports of the United States through exchange rate changes and through the level of aggregate spending on the United States by households in other countries.
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Checking Your Understanding
If the Fed increases its target value for the federal funds rate, what happens to the value of the dollar?
If the ECB increases its target interest rate, what happens to US net exports?
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