What’s it: A closed economy is an economy without transactions with other countries. To grow the economy, it relies on household consumption, business investment, and government spending.
It is impossible to find countries that adopt a closed economy. Almost all countries have interactions with the outside world through international trade, even countries like North Korea.
Comparing a closed economy with an open economy
When running a closed economy, a country has no exposure to the external sector. There is no export or import. Likewise, there are no capital flows or international financial transactions.
The opposite of a closed economy is an open economy. Under an open economy, a country allows the import and export of goods and services. Interaction with the external sector also involves production factors (capital and labor), technology transfer, and intellectual property.
Such interaction also gives rise to a foreign exchange market to facilitate transactions between countries. In the foreign exchange market, we can convert domestic currency to foreign currency, for example, to pay for imported products. Likewise, when we have foreign currency, we can exchange them in this market to get some domestic currency.
An open economy has several advantages. Consumers can access various foreign goods and services, which are unavailable in the domestic market. Producers get some raw materials and capital goods that are unavailable in the domestic market. Investors can also diversify their investment in international financial markets. We can also work overseas for better opportunities.
However, the open economy also has its downsides. Exchange rate risk arises. International capital flows expose the stability of the domestic economy. Economic shocks in one country can also quickly spread to other countries, such as the economic crisis in the United States in 2008-2009.
Several countries later adopt several protective policies. They seek to protect the domestic economy from unfavorable conditions. The government protects domestic industry and employment through import tariffs, quotas, and other non-tariff barriers. To prevent negative excess capital flows, they adopt exchange rate controls and capital controls.
Nonetheless, such protective policies began to diminish as globalization progressed. In recent decades, global trends have led to greater openness. Production, trade in goods and services, capital flows, and labor are increasingly integrated between countries. It is marked by:
- Increased participation of developing countries in world markets
- Expansion of the trade zone towards the establishment of free trade
- Economic integration under a single currency such as the eurozone
- Decreased transportation costs between countries
- Rapid and continuous technological changes, which reach all corners of the world
- Increased transnational and multinational companies’ role in the global production chain
Example of a closed economy
Today, no country has a completely closed economy, not even one like North Korea. It still has trade contacts with other countries, though, tend to be minimal.
Although not actually adopting a closed economy, some countries limit transactions with the external sector. They exercise control over the flow of goods, services, and capital. They also close certain industries from international competition and foreign investment. For example, some oil-producing countries prohibit foreign oil companies from operating in their countries.
Can a closed economy grow
A closed economy is self-sufficient, which means that no imports enter the country and no exports leave the country. The aim of a closed economy is to provide all necessities through domestic production.
Countries with closed economies can grow, but not as high as under an open economy. To grow the domestic economy, it relies on household consumption, business investment, and government spending. All production inputs come from within the country. Likewise, investment in the economy only relies on national savings without foreign capital inflows.
Maintaining a closed economy is difficult in modern society. For example, not all countries have raw materials for production. Many countries are poor in natural resources and are forced to import them from abroad.
Take crude oil, for example. That is not only for energy input but also for various other products, from fertilizers to plastic materials that we use every day. And, not all countries have oil reserves.
A closed economy makes the production of goods highly limited, both in terms of quantity and variety. People are forced to consume what is available, curbing their freedom to consume various goods and services.
A closed economy contradicts the modern economic theory. International trade is the pathway to a prosperous economy. Export is one of the engines of economic growth. When exports increase, domestic production grows. As a result, businesses create more jobs and income in the economy.
To get the benefits of international trade, they should produce goods and services with a comparative advantage. They should allocate labor and resources to the production of goods, which have lower opportunity costs. For comparatively uncompetitive goods, they can import them from abroad, which tends to be cheaper.
GDP formula for a closed economy
Gross domestic product (GDP) shows you the total monetary value of goods and services produced within a country in a given period. In an economic concept, it would equal aggregate income and expenditure.
Under aggregate expenditure, GDP represents the sum of spending on four sectors:
- Consumption by the household sector
- Investments by the household sector.
- Government spending
- Net exports (exports minus imports) by the external sector
Meanwhile, the GDP formula is the same as:
GDP = Consumption + Investment + Government spending + Net exports
The equation above is for an open economy. Since it does not involve exports and imports, then GDP under a closed economy will equal:
GDP = Consumption + Investment + Government spending
So, in theory, GDP grows through the activities of these three sectors.
Advantages of a closed economy
- A more independent economy. The domestic economy meets all needs from domestic resources.
- Avoid exchange rate risks and global economic shocks. Recession or financial crisis spread through international trade and capital flows. Thus, since neither exists, a closed economy has no exposure to these risks. Besides, the exchange rate risk does not apply because there are no transactions with the external sector.
- No pressure from imported products. Domestic producers do not face competition from cheaper foreign products.
Disadvantages of a closed economy
- Limited growth. Lack of domestic resources (factors of production and financial capital) restricts the economy from developing.
- Fewer product variations. Supply only comes from domestic production.
- Excluded from international relations. International trade arises because countries need each other. If that does not exist, the country is deemed not in need of another country.