Question

Carefully explain why monetary policy is likely to be more effective in an open economy than fiscal policy.

Answer 1

Consider the case of inflationary gap in the economy where government / central bank wants to reduce aggregate output and take it to potential level of output.

Fiscal policy is less effective than monetary policy because in open large economy it is very difficult to raise tax and cover deficit by tax revenue because there budget deficit is usually very high. Contractionary monetary policy on the other hand raise interest rate and reduce money supply which will lower investment spending and reduce aggregate demand.