Question

Suppose that Federal Reserve policy leads to higher interest rates in the United States. a. How will this policy affect real GDP in the short run if the United States is a closed economy? b. How will this policy affect real GDP in the short run if the United States is an open economy? c. How will your answer to part (b) change if interest rates also rise in the countries that are the major trading partners of the United States?

Short answer

a) In a closed economy, higher interest rates can reduce real GDP in the short run due to decreased investment. b) In an open economy, a high domestic interest rate can decrease GDP because it could cause the domestic currency to appreciate, making exports more expensive and hence lesser. c) If interest rates also rise in other countries, the impact on GDP due to reduced exports may be less severe than when only domestic interest rates increase.

Step-by-step solution

Closed Economy Impact

In a closed economy scenario, higher interest rates discourage investment as the cost of borrowing increases. This decrease in investment can lead to a decrease in economic activity, hence, reducing the real GDP in the short run.

Open Economy Impact

In an open economy, higher interest rates can attract foreign investors due to potentially higher returns, this elevates the demand for domestic currency, hence raising its value. A stronger domestic currency makes domestic goods more expensive for foreign buyers, leading to a decrease in exports. Since exports contribute to real GDP, if they decrease (while imports remain the same or increase), real GDP can decrease.

Global Interest Rate Rise

If interest rates also rise in major trading partner countries, the investment attractiveness for higher domestic interest rates may reduce, as foreign investors would have comparably high returns in their own countries. The exchange rates may then not change significantly so the decrease in exports may be less extreme. Therefore, the impact on real GDP would possibly be less severe than in step 2.

Key concepts

Closed Economy

In a closed economy, there is minimal interaction with other economies around the globe. Imagine a world where a country operates entirely on its own, without any trade with other nations. All goods and services are produced and consumed domestically.
This scenario simplifies economic analysis, as factors like exchange rates or international trade do not affect the economy.

When it comes to interest rates in a closed economy, if the Federal Reserve implements a policy that raises them, borrowing costs for businesses and individuals increase.

• This discourages investment spending by businesses since loans are more expensive.
• As investment decreases, economic activity slows down, reducing real GDP in the short run.

A closed economy is insulated from international influences, so the impact of interest rate changes is mainly observed through domestic channels like consumption and investment.

Open Economy

An open economy contrasts with a closed economy by actively engaging in international trade. This involvement includes exporting goods and services to other countries and importing goods and services from abroad.
This creates a more complex economic environment where domestic policies can have wider effects due to global interactions.

Higher interest rates in an open economy attract foreign investors looking for better returns on their investments. This situation elevates demand for the domestic currency as foreign investors need it to invest.

• This increased demand strengthens the domestic currency value.
• A stronger currency makes exports more expensive for foreign buyers and can lower export levels.

Since exports directly contribute to a country's real GDP, any reduction due to higher interest rates and a stronger currency may decrease real GDP in the open economy. However, this is only one side of the coin, as imports might become cheaper.

Real GDP

Real Gross Domestic Product (GDP) is a key economic indicator that measures the value of all goods and services produced within a country, adjusted for inflation.
This adjustment gives a more accurate picture of an economy's true performance over time by removing the effects of price level changes.

In both closed and open economies, real GDP serves as a major indicator of economic health. Policies that affect interest rates can influence real GDP in various ways:

• In a closed economy, increased interest rates may reduce investments, thus decreasing real GDP in the short term.
• In an open economy, higher interest rates might influence the volume of exports due to currency valuation, subsequently impacting real GDP.

Understanding real GDP helps economists and policymakers assess the effectiveness of monetary policies like those enacted by the Federal Reserve in controlling inflation and maintaining economic stability.

Federal Reserve Policy

Federal Reserve policy encompasses the tools and strategies used by the central bank of the United States to manage the nation's money supply and interest rates.
The goal of these policies is to promote maximum employment, stabilizing prices, and moderate long-term interest rates, contributing to economic stability.

One key tool is the manipulation of interest rates. When the Federal Reserve decides to raise interest rates:

• Banks increase their lending rates, making borrowing more expensive for consumers and businesses.
• This can lead to decreased spending and investment, influencing both real GDP and inflation.

In a closed economy, these actions mainly affect domestic activity whereas, in an open economy, global repercussions may occur. Changes to Fed policy do not happen in isolation; other countries may adjust their policies in response, which further impacts the open economy's movements and stability.