The Difference between Open Economy and Closed Economy Essay

In the world practice two opposite concepts were formed: an open economy and a closed economy. An open economy is an economy which takes part in international trade and has international financial relations with various countries of the world.

A closed economy is the economy that is not exposed to any influence on the part of international trade, neither exports nor imports of any kind.

Studying the closed economy, we simplify the round model of national income and focus on the analysis of income and expenses within the national economy. Therefore, aggregate demand in the closed economy is represented as sum of the planned consumption, investment and government expenditures:

AD = C + I + G.

The round model of national income in the open economy takes into account the effect of exports and imports. Aggregate demand is sum of the planned consumption, investment, government expenses and net exports expenses:

AD = C + I + G + Xn, where net exports, Xn, is the difference between exports and imports. Exports and imports together characterize the volume of foreign trade of the country (foreign trade turnover).

The nature and structure of economy relationship of various countries with the outside world could be different, so countries differ in the degree of openness to the outside world. This criterion forms the second approach to the definition of closed and open economy. Due to this approach open economies have minimal barriers (obstacles) for economic cooperation with the outside world (countries, which do not have such barriers, practically does not exist). Closed economies are such economies that have significant, sometimes prohibitive obstacles to such cooperation. Mostly it is done to protect domestic producers from stronger foreign market competitors, sometimes to create more favorable conditions for local producers going out to foreign markets. Another difference of open economy from closed economy, as Wouter J. Den Haan and Matija Lozej say, is that “in a closed economy, consumption and investment cannot both increase when productivity is unchanged unless employment increases. If a country can import commodities, however, then it is possible for all domestic spending components to increase without an increase in employment.”

In the closed economy GNP is equal to GDP. In the open economy difference between GNP and GDP is mainly explained by operation of foreign firms on the territory of a given country and domestic firms in other countries.

Unlike the closed economy, in the open economy a freedom of foreign trade transactions occurs, free exchange rate sets and management is exercised through monetary reserves and regulations.

How to determine the degree of openness or closeness of the economy? Sometimes there are attempts to find it out, based on the share data of exports and imports in a domestic product. Halit Yanikkaya argues that, “first, the most basic measure of openness is the simple trade shares, which is exports plus imports divided by GDP.” Barry F. considers that, “the economy is open, if this rate exceeds 5%,” and if this rate is less than 5%, such economy is closed. Countries with the most open economy are Hong Kong, Singapore, New Zealand, Switzerland, and countries with the least open economy – North Korea, Cuba.


However, the share of exports and imports in national product only shows the relative dependence on external trade. Predetermination of the degree of closeness or openness should be done mainly in the exchange mode, which is regulated by the State. Thus, it is necessary to keep in mind that economic relationships with external world are not settled by trade (exports-imports), these are material streams. They include also a movement (streams) of the capital and labor.

In transitive economy processes of transformation of the command economy on the market from the closed to open economy are carried out.

The command economy is, as a rule, the autarchy, i.e. economic isolation, closedness of particular country from the world economic communications. One of theoretical arguments of autarchy supporters is that creation of national economy isolated from the rest of the world protects it from fluctuations of the world economic conjuncture, and consequently, due to this, from the possibility of crisis phenomena with their negative consequences.

The world experience evidently shows that countries with closed economy become poorer than countries that participate in the world economy communications, because they are isolated from new technologies, ideas, foreign investments, etc. Countries with closed economy aspire to sell more than to buy in the world market. Unfortunately, reduction in imports, as a rule, leads to the negative consequences for economy, including exports of the given country.

Liberalization of foreign trade is absolutely necessary in the countries with closed economy, though it seems clear that their internal industries cannot compete with production for import. At a certain stage it can cause an economic crisis, high unemployment and other troubles accompanying an economic crisis. Such fears faced the countries of Latin America in the 80’s and Eastern European countries in the late 80’s/early 90’s. And still entry into the world economic community brings not only negative (it is no secret that non-competitive manufacture will not survive), but also positive results, as the country will have to develop its export potential, which is the factor of internal stabilization.

The key factors of transition from closed economy to open economy, which partially or completely abolish various trade barriers, can be import tariffs, duties, export taxes, import quotas, licensing of imports, etc. Their proper combination means liberalization of foreign trade – the openness of economy.

Therefore, for fast and successful development of national economy, it is necessary to turn to the open economy, which is several times as much more effective than the closed economy.

It has a lot of benefits:

  • a possibility of the country enrichment as a result of exports outweigh imports;
  • a possibility to buy high quality import goods;
  • huge supply (wide assortment of goods, both import and domestic);
  • liquidation of the state monopoly in the market that leads to reduction of prices on the goods as a result of fierce competition;
  • the use of various forms of joint business that allows to gain foreign experience and improve productivity and efficiency of work;
  • creation of free trade zones, which makes it easier for businessmen to cross the borders of adjoining states, that, in its turn, accelerates and increases commodity circulation between two countries;
  • favorable investment climate of the country that improves inflow of foreign investments for progress in the high-technology branches of economy;
  • promotion of competition within the country that stimulates domestic manufacturers to improve quality of goods;
  • the possibility of introduction into the worldwide trade organizations and associations, for example, the World Trade Organization, which reduces the final price of goods in consequence of decrease in import duties between member states of the organization;
  • a possibility of borrowing imported high technologies, which makes products of domestic manufacturers more competitive in the world markets;
  • a possibility of improvement of the country’s managers, as well as managers from small and medium business through participation in international conferences, seminars, exhibitions, etc.;
  • a possibility to build foreign factories on the territory of the State with the latest technology that would provide new jobs and reduce the final cost of the goods;
  • simplification and reduction of import duties, which, in turn, will reduce the value of imported goods;
  • an emergence of banking institutions with foreign capital on the market of financial services, which can offer better interest rates for customers.

In spite of such amount of open economy benefits, it also has its own disadvantages, which are:

  • foreign companies can exploit domestic economy and take money out to their country. Jane Duckett, William L. Miller pointed that inhabitants of East Europe “thought foreign companies exploited rather than helped their country.”
  • an absolute exposure of national manufacturer, which could make it noncompetitive inside the country and could lead to decline of entire branch;
  • an exclusion of national manufacturer from the market at the expense of more quality and expensive foreign companies’ arrival could lead to increase in unemployment within the country;
  • an appearance of transnational corporations in the country, which could entail laundering of their money at the expense of domestic economy;
  • a possibility of capital flow to offshore centers by complete freedom of this flow;
  • if during some period of time imports exceed exports, the expenses on the net exports are negative that could cause reduction in aggregate demand and, therefore, could be a threat to macroeconomic stability.

Thus, the difference between open economy and closed economy is that the aggregate demand in the open economy includes the amount of exports and imports and depends on these indexes, but in the closed economy they are not included. Open economies have minimal barriers for economic cooperation with other countries, and closed economies have significant, prohibitive obstacles. Openness of the economy is determined by several indices; for example, if the sum of exports and imports divided by GDP exceeds 5%, such economy is open. In a closed economy GNP is equal to GDP. Unlike the closed economy, in the open economy there is a freedom of foreign trade transactions, free exchange rate is set and management is exercised through the monetary reserves and regulations. A country with open economy develops up to several times faster than countries with closed economies.

The main benefits of the open economy are free trade liberalization and capital flows; the openness of borders; high-technology import, which favors the development of the country; a possibility of introduction to the worldwide trade organizations.

But at the same time it has a few serious disadvantages. Some of them are the following: an exposure of national manufacturer, which could lead to decline of the entire branch; the national economy could be exploited either by other countries or by transnational corporations or by International trade organizations; decrease of trade balance because of surplus of imports over exports.

So, to have communications with other countries and financial institutions, the country should liberalize its national economy. Closed economies have to take all necessary steps in the direction to transition to a market-oriented economy, even if first steps would not be efficient.

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