The openness of the economy and flexible exchange rates

Question

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The openness of the economy, meaning the extent of foreign trade, and flexible exchange rates increase the effectiveness of both expansionary and contractionary monetary policies. For example, in an open economy, an expansionary monetary policy, such as lowering interest rates, can increase domestic spending and exports, while a contractionary monetary policy, such as raising interest rates, can reduce inflationary pressures and maintain exchange rate stability. Flexible exchange rates allow for automatic adjustments to external shocks, such as changes in foreign demand or supply of goods, which can improve the effectiveness of both types of monetary policies.

The Openness of the Economy and Flexible Exchange Rates