Open And Closed Economy Essay

A Comparison of Open and Closed Economies

2214 WordsFeb 5th, 20189 Pages

The history of an economy can be traced back 5000 years to the Harappan civilization. The Harappan engaged in an open economy involving trade with other surrounding societies (MBARendevous.com, 2012). Not all economies are the same. They are different sizes, depend on different resources for their existence, and provide different amenities to the citizens. Economic theorists consider economies as divided into two different types. One type is an open economy and the other is a closed economy. Both open and closed economies have various advantages and disadvantages for the country. This research will explore the advantages and disadvantages of both open and close economies.
Open Economy An open economy allows for international trade between the home country and other nations. Individuals and businesses can trade goods and services with people all over the world. There is no limit to the number of goods and services that can be traded in an open economy. Most goods can be exchanged, except for those that include infrastructure or other goods and services they cannot be traded due to logistical and practical reasons. However, this does not stop technology and information about the services from traveling across borders in the form of trade. Investments can also be traded across borders. Selling services to a foreign country is…

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Pip Reeve

13.05.09 The Open Economy

1) "For a small open economy the effect of almost any economic policy depends on whether the exchange rate is floating or fixed." Explain/Discuss. A floating exchange rate is one which is set by market forces and is allowed to fluctuate in response to changing economic conditions. This means that there is simultaneous equilibrium in the goods market and the money market. Whereas a fixed exchange rate is where the central bank announces a value for the exchange rate and is prepared to buy and sell the domestic currency to keep the exchange rate at this value. In this essay I aim to predominantly use the Mundell-Fleming model to explain how the effect of economic policies differs between the two types of exchange rate. The key assumptions in this model include perfect capital mobility, a small open economy and therefore the domestic interest rate equals the world interest rate. In this model, the goods market is represented by the following equation: Y = C (Y - T) + I (r*) + G + NX (e) M/P = L (r*, Y)

← The IS* curve
← The LM* curve

Firstly, I will look at how the effect of fiscal policy depends on whether the exchange rate is floating or fixed. I will begin by looking at the case of an increase in domestic government spending under a system of floating exchange rates. This increase in government spending will increase planned expenditure which will in turn shift the IS* curve to the right (as shown in the diagram 1 below).

In this diagram, the LM* curve is vertical as opposed to the upward sloping LM curve in a closed economy. This means that the expansionary policy in an open economy with a floating exchange rate will increase the exchange rate, but leave income unchanged. In a closed economy when income rises the interest rate rises as there is an increase in the demand for money. However, in a small open economy as soon as r begins to rise above r*, capital flows in from abroad in order to take advantage of the higher return, lowering the interest rate back to r*. Also, the inflow of capital increases the demand for the domestic currency, meaning an appreciation of the domestic currency. This makes domestic goods more expensive relative to foreign goods, which reduces net exports. This fall in net exports exactly balances out the effects of the expansionary fiscal policy. So, as r is fixed at r*, there is only one level of income which can satisfy this equation, meaning fiscal policy is powerless to change the level of income in this case. A decrease in domestic taxes will have the same effect, by increasing consumption due to an increase in disposable income, therefore reducing saving. This will raise planned expenditure and shift the IS* curve to the right. The effect of expansionary fiscal policy abroad is quite different, assuming the foreign country is large enough to affect the world interest rate. If this foreign government increases government spending, there will be a reduction in world saving, as the extra spending must be financed by borrowing. This raises the

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