Question

2. Illustration the difference between stabilization policy in a closed versus open economy given an inflation shock (sharply expected inflation).

Answer 1

A close economy has no trade. An inflation shock will require a decrease in aggregate demand which can be implemented using contractionary fiscal or monetary policy. This will lower aggregate demand, lower price level and reduce real GDP.

In a n open economy, a fall in aggregate demand resulting from policy intervention will lower the import demand, which will cause lower demand for foreign currency, depreciating foreign currency and thereby appreciating home currency. A home currency appreciation will make exports less competitive, therefore export demand will fall, further lowering aggregate demand.

Therefore, the decrease in aggregate demand as a result of contractionary policy will be greater in magnitude in the open economy, compared to in a closed economy.

answered by: anonymous