Question

Rank the following three situations according to the ability of monetary policy to affect real output in the short run: (a) a closed economy; (b) an open economy with fixed exchange rates; (c) an open economy with floating exchange rates. Explain.

Short answer

(a) Closed economy, (c) Open with floating rates, (b) Open with fixed rates.

Step-by-step solution

Define Monetary Policy

Monetary policy involves the management of money supply and interest rates by central banks to influence the economy. The main aim is often to control inflation, manage employment levels, and stabilize the currency. In the context of this exercise, we are examining its influence on real output in different economic situations.

Analyze a Closed Economy

In a closed economy, monetary policy can have a direct impact on real output. Since there is no external trade, changes in interest rates directly affect domestic investment and consumption. Thus, if the central bank lowers interest rates, it typically leads to increased borrowing, spending, and investment, which in turn can increase real output.

Analyze an Open Economy with Fixed Exchange Rates

In an open economy with fixed exchange rates, monetary policy is less effective. This is because when the central bank attempts to change interest rates, it must simultaneously intervene in the foreign exchange market to maintain the fixed exchange rate. This intervention often counteracts the intended effects of monetary policy on domestic output, limiting its ability to affect real output significantly.

Analyze an Open Economy with Floating Exchange Rates

In an open economy with floating exchange rates, monetary policy is more effective compared to a fixed exchange rate setup. Changes in interest rates influence exchange rates, which in turn affect net exports and thus real output. For instance, a decrease in interest rates might lead to currency depreciation, making exports cheaper and boosting output.

Rank the Situations

Based on the effectiveness of monetary policy in impacting real output, we rank the situations as follows: (1) A closed economy, where monetary policy directly affects output; (2) An open economy with floating exchange rates, where changes in rates affect exchange rates and thus output; (3) An open economy with fixed exchange rates, where policy measures are limited by exchange rate commitments.

Key concepts

Closed Economy

A closed economy is a system where no goods, services, capital, or money flow between it and other countries. It relies entirely on its internal resources to meet the needs of its consumers and producers. In a closed economy, monetary policy plays a crucial role because there is no foreign trade to influence economic outcomes.

When the central bank modifies interest rates within a closed economy, there is a direct effect on consumption and investment. For instance, if the central bank lowers interest rates, borrowing becomes cheaper for businesses and consumers. This typically leads to increased spending and investment, which can stimulate economic growth and increase real output.

The absence of international trade means that policymakers can use monetary policy with little concern about external factors, making it a powerful tool to control economic activity in the short run.

Open Economy

An open economy stands in contrast to a closed economy by allowing trading of goods, services, capital, and financial assets with other countries. Because of these international exchanges, monetary policy impacts are more complex in open economies.

The effectiveness of monetary policy in an open economy can vary depending on whether exchange rates are fixed or floating. Policies such as altering interest rates can lead to changes in trade balances, currency values, and capital flows. This can indirectly affect real output by influencing imports and exports.

• Fixed Exchange Rates: The central bank's actions are limited due to the need to maintain the exchange rate.
• Floating Exchange Rates: Changes in policy can trigger changes in currency value, which affects trade competitiveness.

Fixed Exchange Rates

Under fixed exchange rates, a country's currency value is tied or pegged to another major currency or basket of currencies. This system requires the central bank to maintain the exchange rate within a specific range by buying or selling its currency.

In an open economy with fixed exchange rates, monetary policy effectiveness is constrained. If the central bank attempts to lower interest rates to boost the economy, this could lead to capital outflows as investors seek better returns elsewhere. This necessitates the bank's intervention to support its currency, often neutralizing its initial policy intent.

Therefore, the central bank's capacity to influence domestic economic activity is limited, as maintaining the exchange rate often takes precedence over policy goals like stimulating growth or controlling inflation.

Floating Exchange Rates

Floating exchange rates occur when the value of a currency is allowed to fluctuate freely according to the foreign exchange market. No central bank interventions determine the exchange rate, making it adaptable to changes in trade and capital movements.

In an open economy with floating exchange rates, monetary policy becomes more potent. For example, a reduction in interest rates can decrease the currency value, making exports more competitive and potentially boosting output.

This flexibility allows the central bank to more directly influence the economy through its policies without needing to maintain a fixed exchange rate, thus enhancing the effectiveness of monetary interventions to adjust domestic output levels in the short term.