Why is monetary policy more effective in an open economy than in a closed economy?
A)Trade deficits affect exchange rates, which can offset adverse interest rate effects.
B)Borrowers can choose to use foreign capital, so that interest rate effects are stronger than expected.
C)Interest rate changes affect exchange rates, so that capital flows reinforce the effect of monetary policy.
D)Banks can choose to lend to foreigners, so that interest rate effects are essentially nullified.

Question

Quizplus · Accepted Answer

In an open economy, interest rate changes affect exchange rates, which in turn influences capital flows. This means that the effects of monetary policy are reinforced by capital flows, making it more effective in achieving its intended goals. In a closed economy, the impact of interest rate changes is limited to domestic borrowing and lending only, which makes monetary policy less effective. Option A is incorrect because trade deficits affect exchange rates, but they do not offset adverse interest rate effects. Option B is incorrect because the availability of foreign capital can make interest rate effects weaker than expected. Option D is incorrect because banks' lending decisions cannot nullify the effects of monetary policy.

Why Is Monetary Policy More Effective in an Open Economy