In this last module of this lesson, I want to bring together for you how the conduct of fiscal and monetary policy, by individual countries, can have an enormous impact on trade, growth and exchange rates in other countries. The key point here is that the global economy is a highly interrelated network of individual countries, engaged in behaviors that often ripple far beyond their shores. Because this is so, it has become increasingly important to the major economies of the world to better coordinate their fiscal, monetary and trade policies. Let me show you what I mean with a few hypothetical examples that illustrate a range of spillover effects from the conduct of domestic fiscal and monetary policies, as well as the implications of the spillover effects for business and investment strategies. Suppose for example, that the United States engages in a contractionary fiscal policy, featuring both tax hikes and reductions in government spending. How might America's contractionary fiscal policy affect the European economy and financial markets? And would you, as an investor specializing in Europe, be more likely to increase your holdings of either European stocks or bonds? So, think about this now and please jot down your answers before moving on. In this case, slower economic growth in America, triggered by contractionary fiscal policy, will reduce the demand for European exports and contribute to a slowdown in the European economy. This will be bearish for the European stock market, so as an investor, you would likely not want to increase your stock holdings. On the other hand, slower growth in Europe should be deflationary, and thereby drive interest rates down and bond prices up. So, increasing your bond holdings, in anticipation of this possible bond price rise, would be an intelligent speculation. It's not just the effects of fiscal policy in one country that can spill over in other countries. The same dynamic is at play with monetary policy. To see this, let me start with this hypothetical. America's central bank, the Federal Reserve, decides to raise interest rates to fight rising inflation. So, how do you think this unilateral action by the United States might affect economic growth in Europe, and the value of the European currency, the euro? To put this another way, would you as a currency speculator, want to go long the euro currency? That is buy the euro. Alternatively, would you prefer to short the euro? That is sell the euro. Take a minute now to think about this, and jot down your answers before moving on. Okay. So, what happens in Europe when America's Federal Reserve raises interest rates? Well, first off, the European Central Bank is immediately faced with the choice of whether it should match the rate hike of the American Fed. As to why the European Central Bank is faced with that choice, I will explain that shortly, but for now, let's suppose the European Central Bank does not respond with a matching rate hike. Here's what happens. In this figure, you can see that as America's interest rate, RA, rises, investors will sell European financial assets and buy American financial assets to take advantage of the higher return. This movement of European capital investment to America, in turn, will lead to an appreciation of the American dollar, ES, and a depreciation of the European currency. Of course, we know that a weaker euro will increase Europe's net exports, EXe, and thereby, raise European output in income, Ye. So in this case, contractionary monetary policy in America may actually boost European growth by weakening the euro and boosting European exports. That would seem to be a very good thing for Europe, but, there still is this problem for Europe. Capital has flowed out of Europe to America, and over time, that is likely to reduce European economic growth. And that is exactly why the European Central Bank must carefully consider whether it should match America's interest rate hike. Let's suppose then that instead of standing pat in the face of an American interest rate hike, the European Central Bank goes ahead and matches that rate hike to prevent capital from flowing to America. What do you think happens now to the rate of economic growth in Europe and the value of the euro? To put this in an applied business context, are you going to be bullish or bearish on European stock market as an investor? Take a minute to jot down some ideas before moving on. In fact, what we have in this case is a very interesting chess match between two central banks, one in America and one in Europe, each trying to promote their own domestic policy agendas. And in this particular chess game, we have assumed that the European Central Bank does indeed match the American Central Bank's interest rate increase to prevent capital outflows from Europe. Of course, this action will preserve the existing exchange rate between the US dollar and the euro, and prevent capital outflows. However, this contractionary monetary policy will also tend to depress domestic investment in Europe, and thereby lower Europe's output and employment. And here's the broader key point and punchline. In its attempt to fight domestic inflation, the Federal Reserve of the United States has increased the chance that Europe will experience a recession. Well, I hope you have found this particular lesson to be as interesting as it was challenging. The fact is, in today's global economy, it is really impossible to implement sound business and investment strategies without a solid grasp of the international systems of trade and finance. And that should be one of the key takeaways of this lesson. I'm Peter Navarro from the Merage School of Business at the University of California, Irvine.
