Question

Suppose the Federal Reserve decides to buy bonds to increase the money supply.

Complete the following paragraph to show the effects of such a policy in an open economy.
Because this isan expansionary monetary policy, aggregate demand willincrease , which causes both real GDP and the price level torise . In a closed economy, this is the total effect of such a policy. However, in an open economy, it is necessary to consider changes to interest rates and thus the exchange rate. Since this kind of monetary policydecreases interest rates, this means that American securities becomeless attractive to foreign investors. This currencydepreciation increases aggregate demand andincreases

Answer 1

Expansionary monetary policy by the Federal Reserve leads to an increase in aggregate demand, a rise in real GDP and the price level, and a depreciation of the currency which boosts net exports in an open economy.

Step-by-step explanation:

When the Federal Reserve decides to buy bonds to increase the money supply, it is engaging in expansionary monetary policy. This leads to multiple effects in an open economy: First, the aggregate demand will increase, causing both real GDP and the price level to rise. In an open economy, this also affects interest rates and exchange rates.

As the Fed buys bonds, the demand for bonds rises and their prices increase, which in turn reduces the interest rate. A lower interest rate makes American securities less attractive to foreign investors, leading to a decrease in the demand for the US dollar, thus depreciating the currency.

This currency depreciation further increases aggregate demand because it makes American goods cheaper overseas and fuels an increase in net exports. Consequently, the aggregate demand curve shifts to the right, stimulating economic growth and potentially closing any recessionary gap.