Question

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

B. Why does fiscal policy have a smaller effect on aggregate demand in an open economy than in a closed economy?

Answer 1

Answer:-

(A).When the Federal Reserve engages in an expansionary monetary policy, it buys treasury securities to lower interest rates and stimulate aggregate demand. In a closed economy, the main effect of lower interest rates is on domestic investment spending and purchases of consumer durables. In an open economy, lower interest rates will also affect the exchange rate between the dollar and foreign currencies. Lower interest rates will cause some investors in the United States and abroad to switch from investing in U.S. financial assets to investing in foreign financial assets. This switch will lower the demand for the dollar relative to foreign currencies and cause its value to decline. A lower exchange rate will decrease the price of U.S. products in foreign markets and increase the price of foreign products in the United States. As a result, net exports will increase. Thus, this additional policy channel in case of open economy will increase the ability of an expansionary monetary policy to affect aggregate demand.

When the Fed wants to reduce the increase in aggregate demand to reduce inflation, then, it engages in contractionary monetary policy. The Fed sells treasury securities to increase interest rates and reduce aggregate demand. In a closed economy, the main effect is once again on domestic investment spending and purchases of consumer durables. In open economy, higher interest rates will lead to a higher foreign exchange value of the dollar. The prices of U.S. products in foreign markets will increase, and the prices of foreign products in the United States will fall. As a result, net exports will fall. The contractionary policy will have a larger impact on aggregate demand, and, therefore, it will be more effective in slowing down the growth in economic activity.

Thus, monetary policy has a greater effect on aggregate demand in an open economy than in a closed economy.

(B). When the Federal government engages in an expansionary fiscal policy, it increases its purchases or cuts taxes. Increase in government purchases directly increases aggregate demand. Tax cuts increases aggregate demand by increasing household disposable income and business income, which results in increased consumption spending and investment spending. An expansionary fiscal policy may result in higher interest rates. In closed economy, the main effect of higher interest rates is to reduce domestic investment spending and purchases of consumer durables. In open economy, higher interest rates will also lead to an increase in foreign exchange value of the dollar and a decrease in net exports. Therefore, in an open economy, an expansionary fiscal policy may be less effective because the crowding out effect may be larger. In a closed economy, only consumption and investment are crowded out by an expansionary fiscal policy. In an open economy, net exports may also be crowded out

When the federal government wants to slow the growth of aggregate demand to fight the inflation, it engages in contractionary fiscal policy. A contractionary fiscal policy cuts government purchases or raise taxes to reduce household disposable income and consumption spending. It also reduces the federal budget deficit (or increases the budget surplus), which may lower interest rates. Lower interest rates will increase domestic investment and purchases of consumer durables, thereby offsetting some of the reduction in government spending and increases in taxes. In an open economy, lower interest rates will also reduce the foreign exchange value of the dollar and increases net exports. Therefore, in an open economy, a contractionary fiscal policy will have a smaller impact on aggregate demand and therefore will be less effective in slowing down an economy.

Thus, fiscal policy has a smaller impact in an open economy than in closed economy.