Monetary Injection in Closed and Open Economy

Monetary Injection and AD

• When the money supply increases, the interest rates

  decrease

  ---

  . This makes it

  cheaper

  ---

  to take loans so Consumption (C) and Investment (I)

  increase

  ---

• This causes Aggregate

  Demand

  ---

  to shift to the

  right

  ---

Net Exports

• In a small open economy with a flexible exchange rate, a monetary injec­tion by the central bank that lowers interest rates will make domestic assets (like bonds)

  less

  ---

  attractive. This causes the dollar to

  depreciate

  ---

  under a flexible exchange rate.
• This causes net exports to

  rise

  ---

• A monetary injection in an open economy shifts the aggregate demand curve

  more

  ---

  to the right than it does in a closed economy.
• A fixed exchange rate is when the central bank does not allow the exchange rate to change between two countries.
• If the central bank tries monetary injection (higher money supply and lower interest rates) with a fixed exchange rate, when the domestic interest rate falls below the world interest rate, everyone would try to buy

  more

  ---

  foreign assets (bonds).
• To do this they would have to exchange their dollars to foreign currency at the central bank which would cause the money supply to

  decrease

  ---

  back to the original level
• For this reason, monetary injection and monetary policy are effective with

  flexible

  ---

  exchange rates, but not

  fixed

  ---

  exchange rates.