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Chapter 29: Problem 2

Why does monetary policy have a greater effect on aggregate demand in an open economy than in a closed economy?

Short Answer

Expert verified
Monetary policy impacts aggregate demand more in an open economy than in a closed economy because of the exchange rate channel. While both economies witness the effects of monetary policy through the interest rate channel, only open economies experience the impacts of the policy through the exchange rate channel. Therefore, changes in monetary policy by lowering or raising interest rates can create a stronger impact in an open economy due to the dual channels of transmission.

Step by step solution

01

Understanding open vs closed economies

An open economy is one that interacts with the other economies in terms of trade and investments. A closed economy is a system that does not interact with other economies of the world. It’s important to understand the difference as the concepts of aggregate demand and monetary policy operate differently in these economies.
02

Identification of Monetary Policy Effects

Monetary policy in an open economy works through the exchange rate, in addition to interest rates. When a country's central bank implements an expansionary monetary policy, it lowers interest rates which weakens the domestic currency. This causes the country's exports to be more competitive, resulting in an increase in net exports and thereby, aggregate demand. This is known as the 'exchange rate channel' of monetary policy transmission.
03

Comparison with a Closed Economy

In a closed economy, monetary policy works primarily through the interest rate channel. Lower interest rates decrease the cost of borrowing and increase investment and consumption expenditure, contributing to a rise in aggregate demand. However, the lack of an exchange rate mechanism diminishes the impact of monetary policy on aggregate demand. Hence, the aggregate demand is less responsive to changes in monetary policy in a closed economy compared to an open economy.

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Most popular questions from this chapter

On January \(1,2002,\) there were 15 member countries in the European Union. Twelve of those countries eliminated their own individual currencies and began using a new common currency, the euro. For a three-year period from January \(1,1999,\) through December \(31,2001,\) these 12 countries priced goods and services in terms of both their own currencies and the euro. During that period, the values of their currencies were fixed against each other and against the euro. So during that time, the dollar had an exchange rate against each of these currencies and against the euro. The following table shows the fixed exchange rates of four European currencies against the euro and their exchange rates against the U.S. dollar on March 2,2001 . Use the information in the following table to calculate the exchange rate between the dollar and the euro (in euros per dollar) on March 2 , \(2001 .\) $$ \begin{array}{l|r|r} \hline \text { Currency } & \begin{array}{c} \text { Units per } \\ \text { Euro (fixed) } \end{array} & \begin{array}{c} \text { Units per U.S. Dollar } \\ \text { (as of March 2, 2001) } \end{array} \\ \hline \text { German mark } & 1.9558 & 2.0938 \\ \hline \text { French franc } & 6.5596 & 7.0223 \\ \hline \text { Italian lira } & 1,936.2700 & 2,072.8700 \\ \hline \text { Portuguese escudo } & 200.4820 & 214.6300 \\ \hline \end{array} $$

Suppose that the current exchange rate between the dollar and the euro is \(€ 0.85=\$ 1 .\) If the exchange rate changes to \(€ 0.90=\$ 1\), has the euro appreciated or depreciated against the dollar? Briefly explain.

What is the relationship among the current account, the financial account, and the balance of payments?

If the exchange rate between the Japanese yen and the U.S. dollar expressed in terms of yen per dollar is \(\$ 115=\$ 1\), what is the exchange rate when expressed in terms of dollars per yen?

In 2016, domestic investment in Japan was 23.4 percent of GDP, and Japanese national saving was 27.2 percent of GDP. What percentage of GDP was Japanese net foreign investment?
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