Quiz 14: Economic Interdependence


Oil price shock causes the business cycles of different countries to be synchronized because a recession in one country often coincides with a recession in other countries and also the changes in one economic variable directly affects all the business related countries. Example : In 1990 when there is uncertainty in the supply of oil, it drove the raise of price automatically. Then the countries which are dependent mostly on it have to pay higher prices to it, whereas, some countries have alternative methods to meet their demands.

In 1990s, events unique to each region had a greater impact on the business cycle in different economies. A weak banking system in the United States, combined with weak growth of construction caused by excess capacity of office space and apartment buildings, led to very slow growth in the early 1990s. Other countries' economies were stronger in this period and did not falter till a decade later. The European economies faced crises in which interest rates rose sharply, causing investment spending on physical capital to be curtailed and sending their economies into recessions. This had some effect on the United States as well keeping U.S. growth lower than it might have been otherwise.

The mechanisms that lead to the international transmission of economic shocks are 1) Trade affects 2) Interest-rate effects 3) Exchange rate effects The basic means by which the transmission occurs are Trade effects: The shocks to one country are transmitted through the trade of goods and services between countries. Ex: If one country is hit with the shock that reduces its income, it will demand fewer imports of goods and services from other counties which reduces the aggregate demand in other countries Interest-rate effects: The shocks can be also transmitted through interest rate. When the people of one country are investing in another country the investments rates in one country affects the flow of investment between the countries. Ex: If the interest rate in country 'A' rises because of a change in the monetary policy in country 'B' that raises the 'A's interest rate and reduces 'A's output Exchange-rate effects : Here the rates of one country trade for currency of another country. Changes in exchange rates affect the demand and supply of both imports and exports of goods and services and also influence how investors decide to invest their savings.