Monetary Policy in an Open Economy

The monetary’ transmission mechanism in the United States .has evolved over the last two decades . as the economy became more open and changes occurred in the exchange-rate system.The relationship between monetary policy and foreign trade has always been a major concern for smaller and more .open economies like Canada and Britain. However, after the introduction of flexible exchange rates in 1973 and in the presence of increasing cross-border .linkages, international trade and finance have come to player new and central role in U.S.macroeconomic policy.

Let’s review briefly the new route using the historical episode just analyzed. When the Federal Reserve tightened money in the 1979-1982 period, this process drove up interest rates on assets denominated in U.S.dollars. Attracted by higher dollar interest rates,investors bought dollar securities, driving up the foreign exchange rate on the dollar. The higher exchange rate on the dollar encouraged imports into the United States and hurt U.S. exports. Net exports fell, reducing aggregate demand. This had the impact of both lowering real GDP and lowering the rate of inflation.

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