[1000 Words; 10 Minute Read] In addition to the more localised economic mechanisms that operate in urban areas, the wider open economy will shape how these economic mechanisms are played out in distributing resources. The open economy can be defined as the economies of all modern advanced industrial nations (and many developing nations) that are open to large volumes of foreign trade and capital movements. This means that the macroeconomic considerations are those where large aggregate values are quantified and traded internationally and include capital goods and services (i.e. those that have the ability to generate further income in the future). These aggregate values will, to a large degree, be generated from producers and consumers in urban areas that make up the national GDP figures that trade internally and externally. So an open economy, as the term suggests, is one where economies can trade openly with others under certain rules of engagement. Most nations do trade openly and there are no closed economies (e.g. Cuba and North Korea still trade internationally), although their economic systems for distribution of resources will differ due to certain political and regulatory frameworks.
More technically, in an open economy, a country’s spending in any given year need not equal its output of goods and services. A country can spend more money than it produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreign rather than domestic nations. This demonstrates how in an open economy the capital flow of goods and services in the form of finance moves freely between nations – and often quicker than most manufactured goods and services. To provide further technical understanding, the individual components of a nation’s output in an open economy are expressed as in the equation in Figure 1.
Figure 1 The equation components of an open economy
Y = C + I + G (X – M)
From Figure 1 it can be seen that the GDP (gross domestic product) for a nation in an open economy is expressed as Y and this is equal to several components. Firstly, C is the level of consumer consumption for domestic goods and services. This consumption could be, say, the aggregate number of electric goods bought within a particular nation. Secondly, I is the level of investment made by a nation in domestic goods and services, such as investment into share capital of companies within a given national boundary. G is the level of government expenditure on domestic goods and services such as the spending on public infrastructure like publicly owned roads, rail and airports.
The important components of an open economy is the difference between exports and imports and these are represented by X – M. X is the output volume of goods and services produced within one nation and sold to other nations, whereas M is the output volume of goods and services that have been produced in another nation but consumed in the nation under study. The net difference between goods and services exported to ‘foreign’ nations and imported in from ‘foreign’ nations is referred to as the balance of trade or the net export. A positive balance of payments at the end of an accounting period (usually one year) will mean that a nation is achieving a healthy balance in that it is producing and exporting more goods than it is importing and thus is economically sustainable if this pattern occurs over the longer term.
In a similar vein, the balance of payments deals with international trading in an open economy by both trade of goods and services as well as financial capital and financial transfers. When all components of the BOP accounts are included they must sum to zero with no overall surplus or deficit. If a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways. A counterbalance could be created in several ways such as by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.
For urban areas, this international trading will play a large contributing factor to its success and failure. Exports from an urban area are certainly the major determinant of short-run fluctuations in the level of economic activity in that area. Single basic industry areas (such as car plants) are also seen to owe their long-run growth to the volume of that basic industry located there. Despite this, economic activities of urban areas are also considered important in relation to whether ‘new’ export activities arise in addition to the basic industry. A decline in the fortunes of the original basic industry will result in stagnation or disappearance of ancillary economic activity – what economics textbooks refer to as a ‘negative multiplier’.
Summary
- In addition to the more localised economic mechanisms that operate in urban areas, the wider ‘open economy’ will shape how these economic mechanisms are played out in distributing resources.
- An open economy is one where economies can trade openly with others under certain rules of engagement. Most nations do trade openly and there are no closed economies (e.g. Cuba and North Korea still trade internationally), although their economic systems for distribution of resources will differ due to certain political and regulatory frameworks.
- In an open economy the capital flow of goods and services in the form of finance moves freely between nations, often quicker than most manufactured goods and services.
- A nation’s output (GDP) in an open economy is a function of consumer spending plus investment plus government spending plus its net balance of foreign trade (as a positive or negative value on the balance of payments).
- Note that in an open economy the balance of payments deals with international trading in an open economy by trading of both goods and services, as well as financial capital and financial transfers.
- A counterbalance to trade deficit could be met by funds earned from its foreign investments, by running down central bank reserves or by receiving loans from other countries.