Question

A country’s government has been running a deficit for the past few years. Suppose this country decides to increase its government spending. Compare the impact of the increase in government spending in a closed economy and an open economy.

Answer 1

Since government spending does not explicitly join the relationship between exports or imports, the relationship between net exports and panel production. Not only does government spending now create a trade deficit, but the impact of government spending on production is smaller than in a closed economy.

The trade deficit and the smaller multiplier have the same cause: demand is now falling not only on domestic products, but on foreign goods as well. Thus, when income increases, the effect on domestic demand is smaller than it would be in a closed economy, resulting in a smaller multiplier. And since some of the growth in demand is imported-and exports remain unchanged-the result is a trade deficit.

Those two are significant consequences. An rise in internal demand in an open economy has a weaker effect on production than in a closed economy, and an unfavorable impact on the balance of trade. Yes, the more transparent the economy, the smaller the effect on production and the greater the detrimental impact on balance of trade. Take Belgium and its import-to-GDP ratio is close to 80%. When domestic demand in Belgium rises, the majority of demand increases are likely to take the form of an increase in demand for foreign goods rather than an increase in demand for domestic goods

Thus, the result of an increase in government spending is likely to be a significant increase in Belgium's trade deficit and only a slight increase in its production, rendering expansion of domestic demand a very unattractive Belgian strategy. Also for the United States, which has an import ratio of just 14%, an increase in demand would be correlated with a deterioration in the balance of trade