The Net Export Effect of Monetary Policy

open economy: an economy that allows the exchange of both goods and assets with other countries

How a Change in the Money Supply Affects Exchange Rate and Aggregate Demand

Expansionary Monetary Policy (increase in money supply) → deprication

• Money Supply Increases → Interest rates fall

• Lower Interest Rates → Domestic financial assets become less attractive to foreign investors

• Less Demand for Domestic Currency → Currency depreciates (weakens)

• Weaker Currency → Exports become cheaper for foreigners, imports become more expensive

• Net Exports Increase → Aggregate demand increases

• Overall: Expansionary policy weakens the currency and boosts aggregate demand

Contractionary Monetary Policy (decrease in money supply) → appreciation

• Money Supply Decreases → Interest rates rise

• Higher Interest Rates → Domestic assets become more attractive to foreign investors

• More Demand for Domestic Currency → Currency appreciates (strengthens)

• Stronger Currency → Exports become more expensive, imports become cheaper

• Net Exports Decrease → Aggregate demand decreases

• Overall: Contractionary policy strengthens the currency and reduces aggregate demand