Second, the foreign recession leads to lower interest rates abroad and, other things being equal, raises the value of the dollar, which in turn lowers U.S. exports and boosts U.S. imports. The dollar appreciation also puts downward pressure on U.S. import prices and, thereby, inflation. The extent to which foreign worries lead to safe-haven flows may add to the dollar’s strength.
Finally, there is contagion to U.S financial markets. Let me first elaborate on the exchange rate channel I just mentioned. The traditional determinants of exchange rates—that is, differentials in expected rates of return—apply to the United States as to other countries. But the U.S. economy is different because of the special role of U.S. government bonds as global safe assets.