Economic Modeling in the Post Great Recession Era

CHAPTER 10 Three-Dimensional Checkers Open Economy, Capital Flows, and Exchange Rates

Since the Great Recession, the importance of global capital flows and foreign economic policy has become increasingly relevant to financial (bond and equity) and real (real estate) asset prices across many countries. In a traditional view, a country’s economy may be viewed primarily as a stand-alone subject. That country can grow at a pace determined by internal forces (demographics, economic policies, or regulatory change) unless acted upon by an external force. Economic policy is conducted on primarily a domestic basis. In this way, some analysts would follow the path of Isaac Newton’s first law: an individual object will continue to move in a state of constant velocity unless acted upon by an external force. Unfortunately, for the domestic-centric analyst, Newton did not stop there.

NEWTON’S THIRD LAW

Newton’s third law, instead, focused on the interactions between different bodies (e.g., the United States and other nations) and that there is no such thing as a unidirectional force, or a force that acts on only one body. The evolution of commentary by the Federal Open Market Committee (FOMC) with respect to “global economic and financial developments” is exhibit number one.¹ Whenever a first body (the U.S. economy) exerts a force on a second body (the global economy), the second body also exerts a force back on the first body. In a manner similar to Newton, and despite the urging of Aristotle, ...