[MUSIC] Our next question is this. How does the United States maintain a chronic trade deficit, even though it operates under a largely flexible exchange rate system? Under such a system, shouldn't there be a natural adjustment of the US balance of payments due to the forces of supply and demand? After all, US trade deficits should lead to a surplus of dollars in foreign exchange markets and thereby drive down the dollar's value. This in turn should lower the price of the country's exports, increase the price of its imports, and restore balance to US trade flows. But such an adjustment process has not worked particularly well in curbing the chronic trade deficits of the United States. The question is why and the answer lies in first understanding the nature of the US trade deficit. There are several reasons for persistent US trade deficits. The first of course, is the large, chronic budget deficits that began in the 1980s. As we have discussed, the need for the government to finance these budget deficits drove up interest rates, strengthened the dollar, made exports more expensive and imports cheaper, and sent the trade deficit spiraling upward. That's not all. A declining savings rate in the US has also been a major contributing factor to the trade deficit problem in this sense. As the US savings rate has fallen, the investment rate has remained fairly stable or even increased. This has been possible because foreign investment has filled the savings-investment gap. One result, is that US citizens have been able to save less while consuming more. And at least part of that increased consumption has been on imported goods. In this sense, the US capital surplus may not only result from the trade deficit but also help cause it. These two major causes of the US trade deficit are each driven in some degree by US domestic fiscal and monetary policies. Because this is so, we must now come to understand how the conduct of domestic, fiscal, and monetary policies in a global economy can affect not only the domestic country's trade balance. This conduct can also significantly affect the rates of growth and unemployment in the domestic country's trading partners. And here's the punchline. Any imbalances in either capital or trade flows in one country will affect all trading partners. This means, for example, that the US trade deficits and capital surpluses are not just domestic headaches, they are global problems as well. Perhaps the best way to understand this important point is to illustrate the mechanisms through which domestic fiscal and monetary policies actually affect the global economy. Let's look at fiscal policy first. Suppose then, that America's GDP falls. This might happen as a result of contractionary fiscal policy to slow inflation. Or it may simply be that demand in the private sector is weak. Regardless of the reason, the result is the same. And it is illustrated in the chain of causality in this figure. Lower income in America, you, leads to lower exports from Europe, ImA. And the flipside of this coin, of course, is that as European exports, EXE, to the US falls, so too does European income, YE. In other words, America's domestic fiscal policy cannot only lead to a contraction in the American economy, it can also function as a contractionary fiscal policy for Europe as well. In some textbooks, this chain of causality is referred to as the Multiplier Link. And from this Multiplier Link, you can perhaps see why it is grown increasingly important for countries to coordinate their fiscal policies. For example, suppose that America wants to reduce its trade deficit with Japan. Based on our discussion thus far, one way to do this, might be for the US to adopt a more contractionary fiscal policy. However, such a policy might not be politically acceptable on the home front if the US economy is in recession. Alternatively, the US might encourage Japan to adopt a more expansionary fiscal policy as a way of stimulating Japanese demand for US imports and strengthening the yen relative to the dollar. In fact, this is precisely the kind of request that an American President might make to the Japanese Prime Minister at a bilateral trade summit. And such a coordinated macroeconomic approach can work but only if each country benefits. For example, if Japan is in a recession with low inflation, it may well agree to the fiscal expansion. However, if Japan is at or near full employment, it may simply refuse any fiscal stimulus for fear of igniting inflation. Now let's look at the impact of domestic monetary policy on the global economy. Specifically, let's consider what happens in Europe when America raises its interest rates through contractionary monetary policy. This is illustrated in this figure. As America's interest rate, rA, rises, investors sell European financial assets and buy American financial assets. This leads to an appreciation of the dollar, eS, and a depreciation of European currencies. This in turn increases Europe's net exports, EXE, and thereby raises European output and income, YE. Note however, there is an important offsetting effect. In particular, higher interest rates in America tend to raise European interest rates, rE. These higher rates tend to depress domestic investment in Europe, IE, and thereby lower Europe's output, YE, and employment. In other words, in its attempt to fight domestic inflation, the Federal Reserves of the United States has increased the chance that Europe will experience a recession. In some textbooks, this chain of events is referred to as the Monetary Link. And here's an important point regarding this link. Unlike with fiscal policy and the Multiplier Link, the overall impact of monetary policy and the Monetary Link on domestic GDP is ambiguous and will depend on the particular situation. This point is reinforced in this figure. It illustrates the impact of contractionary monetary policy in a closed versus an open economy. Note that in a closed economy, a cut in the money supply reduces consumption and investment and helps relieve inflation pressures. However, if the money supply reduction increases domestic interest rates, this may trigger additional capital inflows. And these increased capital inflows may frustrate monetary policy by increasing the money supply and holding down interest rates. These lower rates, in turn, may increase aggregate demand. The increased capital inflows may also tend to increase the value of the US dollar and widen the trade deficit. Our bottom line here, is that the net impact of the contractionary monetary policy on domestic GDP is theoretically ambiguous and will depend on the individual case. However, what should be unambiguous from this example is the critical importance of globally coordinating, not just fiscal policy, but monetary policy as well. A more real world example should strongly reinforce this point at the same time that it highlights the difficulties of achieving such coordination.
