NCPA - National Center for Policy Analysis

Understanding International Trade and Financial Markets is Key for Globalization

March 12, 2015

The rapid financial globalization of the past 30 years poses many challenges to policymakers in the United States and around the globe. When making decisions at home, they can no longer ignore changes abroad. Policymakers must better understand the interaction among domestic and foreign economies through international trade and financial markets as they seek to maximize their nation's welfare.

International trade growth varies substantially the more a nation's total output grows over time. However, standard models substantially underestimate a foreign country's influence through international trade on a domestic economy and may provide misleading policy suggestions.

The exchange rate is a focal point of international economic activities. Exchange rate fluctuations alter the relative prices of goods and services between countries and therefore substantially affect international trade. Aggregate price levels are an important channel through which the exchange rate affects the real economy.

Besides international trade, the exchange rate plays an important role in international financial markets. Studies show that if the central bank takes a strong stance on inflation, exchange rate stabilization can improve welfare by fine-tuning interest rates to alleviate international price distortions caused by noisy exchange rate movements and sticky prices. For countries that do not appropriately anchor inflation, stabilizing the exchange rate through monetary policy will substantially increase macro instability and reduce overall welfare.

Following the 2008 financial crisis, the Federal Reserve instituted several rounds of QE to stabilize the financial markets and aid U.S. economic recovery. QE policy in the United States inevitably spilled over to other countries through exchange rates and interest rates. The central banks in other countries should continue to focus on inflation stabilization and let exchange rates run their course. Unfortunately, policymakers could not restrain themselves from loosening monetary policy to stabilize their currency's value. As a result, countries focusing more on exchange rate stabilization during this period suffered higher inflation and less-stable domestic macroeconomic conditions.

Source: Jian Wang, "Understanding Trade, Exchange Rates and International Capital Flows," Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute, 2014 Annual Report. 


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