Because this is an open economy, which leads to a consideration of international capital flows, the direct impact of such a policy is a decrease in domestic interest rates. As the Federal Reserve buys bonds, the demand for bonds increases, driving up their prices and consequently lowering interest rates. Lower interest rates make borrowing more attractive, leading to increased spending and investment by businesses and households. This is known as the interest rate effect.
However, in an open economy, it is necessary to consider changes to interest rates and thus the exchange rate. As the domestic interest rates decline, capital flows may shift internationally in search of higher returns. Foreign investors might find the higher interest rates in other countries more attractive, causing a depreciation of the domestic currency. This kind of monetary policy affects the exchange rate, influencing the relative attractiveness of U.S. securities to foreign investors.
When U.S. securities become less attractive, there is a capital outflow, putting downward pressure on the exchange rate. This depreciation makes exports more competitive and imports more expensive, leading to an improvement in the trade balance. Consequently, aggregate expenditure will increase in both real GDP and the price level. In a closed economy, the impact would primarily be through changes in interest rates and domestic spending.
In an open economy, the effect extends to the exchange rate and net exports. The currency depreciation boosts net exports in the short run, contributing to the overall impact on the economy. However, it's essential to note that the effect of this monetary policy on GDP is generally smaller in an open economy than in a closed one due to the additional considerations of international capital flows and exchange rates.
Therefore, the statement "The effect of this monetary policy on GDP is smaller in an open economy than in a closed one" is generally True.