Open economy

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What is an Open Economy?

Based on the free movement of labor and trade, economies are classified into open and closed economies. It is notable that in the contemporary scenario, all countries of the world engage in trade because no one can produce enough of all necessary commodities that are required in an economy. Based on the mode and process of international trade transactions, economies are classified as open and closed.

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Image 1: An open economy

A society is deemed to have an open economy considering the following factors −

  • Output market − An economy that deals openly to trade commodities and services with international clients or on its own is known as an open economy. The output market broadens the preferences of economies by permitting manufacturers and customers to choose between foreign and domestic commodities.
  • Financial Market − An economy can engage in the active purchase of financial assets frequently from a foreign country or produce enough to meet its own needs to be an open economy.
  • Labor market − An economy can exchange, buy, or locate manufacturing plants wherever they need, and it may exchange labor to be an open economy.

Hence, an open economy is a system where the markets are broadened to such an extent that a closed economy can never achieve such limits.

Balance of Payments (BoP)

Entities and economies are usually required to keep the statement of every transaction it makes with other economies or nations for a certain period of time. Such statements are known as Balance of Payment (BoP). BoP records current accounts (those that are visible or invisible) or capital account transactions (such as Foreign Direct Investment or FDI).

In other words, BoP is a statement that records transactions between the governments, organizations, and individuals of one nation with governments, organizations, and individuals of another nation. These exchanges may include commodities and imports of products, capital, and administration. There may also be move installments like settlements and unfamiliar guides.

A nation’s equilibrium between its net worldwide speculation position and installments makes up its global record.

The total installments recorded that are yet to be determined by installments should be zero, which is also the length of the capital records characterized exclusively. The reason for this is that each credit shown in the current record has a comparing charge in the capital record and vice versa.

A nation imports unfamiliar capital when it trades a thing (current exchange) by paying for it (capital exchange). When a nation cannot finance its imports through commodities of capital, it should do so with its reserves.

The current circumstance is referred to as an equilibrium installment deficiency. This should be carried out by using the limited meaning of capital record that cancels national bank saves.

BoP Deficit and BoP Surplus

The diminishing amount in total reserves of a country is known as the BoP deficit while the increase in reserve is known as the surplus. Therefore, a deficit means that there is less addition of resources while a surplus means that the resources have increased.

The balance of payment deficit or surplus is obtained after adding the capital account and current account balances. In general, the formula for BoP is −

BoP = Balance of Current Account + Balance of Capital Account + Balance of Financial Account

The balance of payments surplus is considered an addition to official reserves.

Fixed and Flexible Exchange Rates

There are mainly two types of exchange rate systems in the economy, namely −

  • Fixed Exchange Rate
  • Flexible Exchange Rates

The fixed exchange rate is usually determined by authorities, whereas the flexible rates are determined by market forces of demand and supply. In the case of flexible exchange rates, the value of a currency is allowed to go up and down according to the market forces of foreign exchange.

Here are the differences between fixed and flexible rates −

Fixed Rate Flexible Rate
In fixed rate, the government rate decides the value of the currency and it is fixed. The flexible exchange rate is determined by the market forces of foreign exchange or the demand and supply of the currency in the market.
The fixed exchange rate is governed by central authorities. The flexible rate is determined in the market depending on demand and supply forces.
In the cases of fixed rates, the currency is devalued. The currency is revalued when there is a change in its international value. There is either appreciation or depreciation in the value of the currency in the case of flexible rates.
The authority to reserve the rights of interest rate lies with a government bank in the case of the fixed rate. In the case of flexible rates, there is no such authority or involvement of government banks.
In the case of fixed rates, there is a need to maintain foreign reserves. In the case of a flexible rate, there is no need for the maintenance of foreign reserves.
In the case of a deficit of BoP, the fixed rate cannot be adjusted. In the case of the BoP surplus, the surplus is automatically adjusted.
Trade Deficits, Savings, and Investments

Trade Deficits

Trades are indispensable for economies. However, to have better health for the economy, trade deficits and surpluses must be monitored. A trade deficit occurs when imports exceed exports while a surplus occurs when exports are more than imports. Therefore, trade deficits show a negative balance of trade.

  • A trade deficit may not always be detrimental to an economy. When the local products cannot meet the demand of the markets. Imports may also go up when consumers’ purchasing power increases so that they can afford foreign products that have higher costs. In such cases, the domestic producers get an opportunity to produce goods that are in demand and this helps the economy to grow.
  • As the goods produced domestically are of lower costs, inflation comes down while the consumers also get an opportunity to choose from local and foreign items which increases the span of consumer choice. This leads to a fast and growing economy where more investors are interested to put their investments.
  • Trade deficits for a longer period, however, may be detrimental. This happens when imports lag behind exports by a wide margin. In such circumstances, prices of goods go too down to let local manufacturers able to produce goods managing profits. Therefore, unemployment increases as people lose jobs while companies engage in manufacturing less than what an ideal situation should be. This increases imports further to enhance trade deficits.

Savings and Investment

Savings and investment are closely related terms. Savings refer to excess income left over expenditure and investments, whereas investment means putting money into initiatives that tend to increase capital.

The balance between national savings and income shows the equilibrium between savings and income, according to Keynes's theory. When savings are used for investment, capital is generated which is used in situations of trade deficits for economic growth.

Savings, however, does not always mean investment. Savings must be deposited to financial intermediaries; such as banks to convert them into investments. The balance of savings and investments has short and long-term effects on the economy.


An open economy is often a sought economy because it offers greater flexibility and has more opportunities to flourish. However, certain principles, such as BoP, savings, and investments must be kept in the mind to get better prosperity. Still, as an open economy provides more chances to grow and make people earn wealth more in quantity, it would continue to be a preferred choice of economists over other forms of economy.


Q1. What is an open economy? Why is it preferred over a closed economy?

Ans. An open economy has greater openness in terms of trade in output, financial, and labor markets. There are greater exchanges of assets in these markets and due to the greater flexibility, open economies are preferred over closed economies.

Q2. Why do countries cannot have completely closed economies?

Ans. There is no country in the world that can produce all commodities required to make a living for its consumers. Therefore, countries must depend on one another and have an open economy.

Q3. Is trade deficit always harmful to an economy?

Ans. The trade deficit is not always harmful. In the short run, it may be a driving force for a fast, growing economy.

Updated on 13-Oct-2022 11:19:47