Closed Economy

Closed Economy

Introduction:

A closed economy is a situation where the economy does not have the exports and imports, interest rates and money supply are the monetary policy tools used by the government to ensure that there is proper economic growth and employment in the economy. According to Keynes a closed economy has the following model: Y = C + I + G where Y is the national output or income level, C is consumption, G is government. In an open economy however Keynes derived the following model: Y = C + I + G + (X – M) where X is exports and M is imports.

In this paper we discuss the effect of doubling quantity of money, an increase in willingness to work and a fall in propensity to save, and their effect on the interest rates, price levels or inflation and the level of national output.

Doubling the nominal quantity of money:

The nominal quantity of money can be defined as the money measured with a particular currency and the quantity is directly proportional to the level of prices, in this case therefore the nominal quantity of money is equal to the price level multiplied by real money, where real money is the quantity of money and is usually a constant.

The doubling of nominal quantity of money can be analysed using the quantity theory of money which states: MV = PQ where M is money supply, V is the velocity of money, P is prices and Q is the output level. PQ therefore is the nominal value and as the equation depict if this doubles then the other side which is MV must also double. Therefore we expect that the money supply

Closed Economy

will have increased and as a result then the inflation level will rise, inflation is the increase in the price level in the entire economy.

Effect of doubling the nominal quantity of money on the price level and output:

When the nominal quantity of money doubles then the level of prices to rise in the economy, as the level of prices increase then we expect also that the output level will increase as more investors and producers produce more goods and services due to the high prices in the economy.

Effect of doubling the nominal quantity of money on the interest rates:

When the level of nominal quantity of money increases then we expect the level of interest rates to increase, the increase in interest rates will be a policy measure to ensure that the money supply in the economy is reduced in order to deal with the high inflation level in the economy. For this reason therefore the interest rates will rise in order to reduce the money supply.

Increase in the willingness to work:

An increase in the willingness to work will result into increased labour productivity, an increase in labour productivity will result into an increase in output and at the same time save on costs of labour. When labour productivity increases then the prices of goods will definitely decrease as the cost of production will be lower. For this reason therefore the price of goods in the economy will decrease.

Closed Economy

Effect of increased willingness to work on output and price level:

Therefore the increase in the willingness to work will first result into an increase in the output in the economy. The price level in the economy is also expected to drop as the cost of production reduces. The diagram below shows the effect of an increase in the willingness to work on the supply curve which will also result into a change in the price for final goods;

From the above diagram as the willingness to work increases then the cost of production reduces and as a result there is a shift in the supply curve as shown above and as a result there will be a decline in the price of goods in the economy where the price will be lower than the current equilibrium point in the market. The output will also increase as shown above because more goods will be supplied in the economy and the news equilibrium point will depict a higher level of equilibrium quantity and a lower equilibrium price as shown above.

The effect of the increase in willingness to work on interest rates:

When the willingness to work increases in the economy increases then this will result to an increase in the productivity level, under this case therefore there will be a reduction in the interest rates in order to stimulate demand for goods and services as more products will be produced in the economy. A reduction in the interest rate level will result into increased level of money supply which will increase demand and at the same time stimulate investment in the economy. Therefore when there is an increase in the willingness to work the interest rates are likely to be reduced.

A fall in the average propensity to save:

When the propensity to save decreases then this will be as a result of a reduction in the level of savings in the economy, because savings and investment are directly related then the result of this will be a reduction in the level of investment.

Interest rates can be defined as the cost for funds borrowed and also the level of interest rates will also determine the level of earnings from savings, when the level of savings decline then the

Closed Economy

level of interest rate can be increased in order to increase the level of savings as incentives to save increase.

From the above graph as the level of savings decline then the level of investment will also decline.

Effect of a decline in average propensity to save on output and prices:

As the level of savings decline the level of investment will decline, as the level of investment decline then the level of national output will also decline as this will mean that the goods and services produced in the economy will decrease as the level of investment declines.

Prices will also rise in the economy as a result of reduced supply of goods and services. This will because the demand for goods and services exceed the level of supply for the products in the economy and this will lead to an increase in price level of goods and services.

The diagram below demonstrates the decline in output as a result of a decline in the savings level

Income or output

From diagram one it is clear that as the level of savings increase then the level of output also increases, in our case our level of savings decrease and therefore we expect the level of output to also decrease.

Effect of a decline in average propensity to save on interest rates:

Closed Economy

In diagram two the IS curve depict what happens when the level of interest rate shift, when interest rate increase then the level of output declines, when the level of our interest rates decreases then the level of output increases, therefore we expect that the level of interest rates to be reduced by the government in order to increase the level of output.

Investment and interest rates:

The diagram shows the relationship that exist between investment and interest rates,

From the above diagram as the level of interest rates increase then the level of investment declines, therefore in this case because the level of savings has reduced the government will want to increase the level of investment and for this case therefore it will reduce interest rates in order to increase investment which will in turn increase output in the economy.

Conclusion:

When changes in the economy occur as above then the government has interest rates and money supply to fine tune the economy to achieve higher economic growth and also maintain low levels of inflation. Inflation may lead to a recession which is characterised by low level of interest rates, low investment and economic output.

When the nominal quantity of money doubles we expect the level of prices to rise, output will also increase because of the increased price incentive for producers and finally the interest rates will rise. When the willingness to work increases the price of goods is expected to decrease, the output level is also expected to rise as a result of increased labour productivity, interest rates will decrease in order to encourage more investment in the economy. A decline in the average propensity to save means that the savings levels have declined and therefore low investment in the economy, for this reason the output level will decline, prices will rise and the interest rates will be reduced in order to encourage investment.

Therefore the government will increase interest rates to get rid of inflation but also reduce interest rates in order to increase the level of output. When the interest rates are decreased

Closed Economy

then prices will rise and this will lead to inflation in the economy, if the government increases interest rates then the level of investment will be low and therefore low levels of output but the economy will experience low inflation. Therefore any policy measure to increase or reduce interest rates will take into consideration the negative and positive effect on the economy such as higher output and also inflation.

References:

Philip Hardwick (2004) Introduction to Modern Economics, Pearson Press, New York

Stratton (1999) Economics: A New Introduction, McGraw Hill Publishers, New York

Anthony Samuelson (1964) Economics, McGraw-Hill publishers, New York