Explain how a shock in one country can be transmitted to other countries. List three ways this can happen and give an example of each.

Question

What will be an ideal response?

Answer 1

Shocks are transmitted internationally via trade effects, interest-rate effects, and exchange-rate effects. Trade effects occur when the demand for exported goods changes; for example, when an increase in income taxes in country A reduces people's after-tax income, they buy fewer goods, including imported goods, so net exports in country B decline and income in country B declines. Interest-rate effects occur because investors can move investments into different countries; for example, if country A eases monetary policy, reducing its interest rate, investors will move their financial investments to other countries, reducing interest rates in those countries and influencing investment and consumption decisions in those countries. Exchange-rate effects occur when the exchange rate changes, changing the relative prices of imported and exported goods; for example, if country A's currency declines in value, making its exports cheaper, people in country B buy more of country A's exports, reducing their own net exports, thus reducing income in country B.