Define the following terms and explain their importance to the study of macroeconomics:

Question

a. open economy
b. closed economy
c. budget deficits and trade deficits
d. international capital flows

Answer 1

a. An open economy is one that trades with other nations in goods and services, perhaps also in financial assets. The United States and its major trading partners are good examples of open economies. Open economies are characterized by less powerful fiscal policy and more powerful monetary policy than closed economies.
b. A closed economy is one that does not trade with other nations in either goods or services or assets. North Korea may be one of the few closed economies left in the world. A closed economy is of limited theoretical interest, because so many nations are integrated into the international economy.
c. A budget deficit must be financed and tends to raise real interest rates. An increase in real interest rates will cause currency appreciation, a drop in exports, and an increase in imports, which together can lead to a trade deficit. The trade deficit decreases GDP, thus weakening the expansionary effect of fiscal policy.
d. International capital flows move in response to changes in interest rates. In an open economy, which permits transactions in financial assets, capital flows affect exchange rates and interest rates. The effect of international capital flows is to increase the power of monetary policy, and decrease the power of fiscal policy.