Answer to Question #51397 in Macroeconomics for Yoyo

Question

Explain why each of the following statements is True, False, or Uncertain according to economic principles. Use diagrams where appropriate.
An economy that is open to capital flows has two channels for the monetary transmission mechanism, while an economy closed to capital flows has only one. [Hint: Explain in the context of an increase in interest rates in both types of economies.]

Answer 1

The monetary transmission mechanism describes how policy-induced changes in the nominal money stock or the short term nominal interest rate impact on real variables such as aggregate output and employment. Specific channels of monetary transmission operate through the effects that monetary policy has on interest rates, exchange rates, equity and real estate prices, bank lending, and firm balance sheets. Recent research on the transmission mechanism seeks to understand how these channels work in the context of dynamic, stochastic, general equilibrium models. The main impact is through the level of aggregate demand. Higher interest rates limit people's ability to spend and so reduce aggregate demand. However, there are a variety of other effects as well through expectations, asset prices and the exchange rate. That's why, an economy that is open to capital flows has two channels for the monetary transmission mechanism, while an economy closed to capital flows has only one.
So, the statement is True.