Question

Explain the conditions under which monetary policy may be effective in an open economy

Answer 1

In an open economy, the monetary policy is effective in case of a flexible exchange rate system. However, in case of the fixed exchange rate system, any changes made by the Fed to stimulate or affect the economy would not work.

Let us see how it works: In case of floating exchange rate system, suppose the Fed change the interest rate. This change in interest rate would affect the investment and consumption in the economy. On the other side, the change in interest rate would also affect the demand for dollars to invest in the US (which would decline in case of a decline in interest rates). This will further reduce the exchange rate or the foreign currency price of the dollar. The weaker dollar means the exports would become cheaper and thus increase while the imports would decrease. Thus, change in the interest rate in an open economy under the flexible exchange rate regime does not affect only the exchange rate but also the net exports.