What Is The Link Between Financial Markets And Interest Rate Effects?

While the multiplier link works through the current account, the monetary link operates through financial markets. Under flexible exchange rates, large countries have room to change their monetary policies. When central banks raise interest rates through a monetary tightening, the higher interest rates attract funds and the country's foreign exchange rate tends to appreciate. This in turn reduces exports, raises imports, lower output, and slows inflation. Empirical studies on the United States have found that the international transmission mechanism for monetary policy is just as powerful as the domestic mechanism.

But here again we find that the domestic policy spills over to other nations. Consider what happens in Europe when America raises its interest rates. As America's interest rate rises, investors sell European financial assets and buy American financial assets. This leads to an appreciation of the dollar and a depreciation of European currencies. It also tends to raise European interest rates.

There are a number of affects on America's trading partners. The higher interest rates tend to depress domestic investment in Europe and thereby to lower Europe's output and employment.