Closed Economy of North Korea - Essay Example

Running Head: Closed Economy Closed Economy [Institute’s Closed Economy Introduction Consider the situation of North Korea today. The country is currently becoming very famous due to its nuclear program, which United States and other powerful countries of the world see as a threat for them. Therefore, United States has been constantly warning North Korea to stop its nuclear program or else it would have to face some serious consequences. Not only United States but also many other countries have closed their doors for trade, exchange, diplomatic relations and any kind of noteworthy contact with North Korea, leaving it in isolation. However, North Korea according to the last news is still very much interested in pursing their nuclear program and is actively engaged in it. The question here is that why it is not concerned with the threats of United States. Let us not answer this question now and move a little further before answering this question. Official Statistics show that North Korea had an average annual growth rate of around 1.6 percent for the period of 2002-2007 (Walters, pp. 55-57, 2008). However, it shocked the world when it posted a growth rate of more than 3.7 percent in the year 2008 (Library of Congress, pp. 15-19, 2009). Not only had this shock came because this growth is the highest for North Korea for at least the past two decades but also because many neighboring countries of North Korea and even many other countries had either showed negative growth rates for the year 2008 due to the global financial recession. The second question is that what magic lamp North Korea had to show this comparatively unusual and high growth rate during the period of global financial recession and why there was no affect of the recession on its growth. The answers of both these questions lie in the economic structure of North Korea. North Korea is the country, which is the nearest of being called as a closed economy or autarky. It is one of the five remaining socialist states of the world with an entirely government planned, state owned and command economy where the government intervenes largely. Interestingly, North Korea is a completely nationalized state and state owns all the assets of the country. Moreover, the citizens do not have to pay any taxes. More importantly, it has trade relations only with countries like Iran, Russia, Syria, Vietnam, and China (Library of Congress, pp. 15-19, 2009). Significant here to note is that all these countries are Anti-United States and that is why their names are there. Quite understandably, North Korea does not have all the resources that they require and they also do not have all the buyers for their products and services but being a closed economy means that North Korea has somewhat found a way to fulfill their needs with the existing resources. Moreover, they do not export much to other countries, try to consume as much as they can in their internal market and export little to the above-mentioned countries. Despite the fact that the North Korean model does not fulfill the ideal and perfect definition of a closed economy but there is no country, which is closer of being a close economy than North Korea. However, this same list includes countries like Cuba, Iran, and Bhutan, which are somewhat close to being an autarky. This paper moves on to the next section since the former section has presented a complete introductory picture of a close economy and this would serve as the basis of discussion for the latter sections of the paper. The next section of this paper would discuss the impacts of three economic policy decisions on interest rates, the price level, and the output of the economy. Discussion A. Doubling the nominal quantity of money Money is the one of the most interesting and fascinating topics of economics. Nominal quantity of money simply refers to the money supply of the economy. Quite understandably, money supply has a lot importance in economics whether studying open or closed economy. This is because of the fact that almost all of the monetary policy depends upon the alteration of the money supply. Monetary policy actually includes both, money demand and money supply but only money supply is something, which is alterable and changeable in the very short run or short run. On the other hand, generating demand for money or decreasing the demand for money is a medium term phenomenon, if not a long-term activity. Therefore, economic decision makers of the country love playing with the money supply of the economy for achieving their goals and objectives for the economy. Increasing money supply or increasing the nominal quantity of money is the easiest and the most disastrous step in the end for any economy. Easiest because of the fact that it just requires them to ask the Bank of England or Central bank to print the desired amount of new notes and the Bank of England does it over night. However, in the end, it increases the inflation and the cost of living that affects the working class of the country seriously, if this increase in inflation is not accompanied with some other measures to balance these affects (Baumol & Blinder, pp. 467-491, 2007). The upcoming lines of this paper would explain that how does it happen. On the other hand, decreasing the money supply in any economy is an effort taking and time taking activity. It not only refers to the fact that the country would stop printing any new notes but also that the economy would actually suck a desired and calculated portion of money from the market. This would require nothing but an open market operation that the Bank of England would have to perform by issuing saving certificates, T-bills, treasury bonds, and other creative ways of persuading the public to let them hold their money for some period. However, we are here more concerned with understanding the affects of printing new currency notes for the economy. The graph presented below helps us to understand the affect of an increase in the money supply on the interest rates. On the X-axis of this graph is the money stock or nominal quantity of money and on the Y-axis remains the interest rate of the economy. The vertical line of the graph is the line representing the money supply, which is constant for all interest rates. Quite understandably, it shows that it does not depend on interest rates and as well will see that interest rate depends on the money supply. Now, as the discussed situation implies that there is a doubling in the nominal quantity of money, which means that the line of MS moves towards the right, almost with the same distance as it away, from the Y-axis at this initial point. Now this new line of money supply would form an equilibrium point lower as compared to the previous equilibrium point thus indicating the fact that the interest rate would have to decrease to attain equilibrium. Therefore, we can conclude that with a double increase in the nominal quantity of money or money supply, the interest rate would have to fall depending on the slope of the money demand curve (Baumol & Blinder, pp. 467-491, 2007). (Monetary Freedom, 2009) However, it is also important to understand that why does it happen so. Doubling the money supply would mean that government or the Bank of England has decided to increase the money in circulation in the market. Suddenly, people would find more money in their hands for spending and saving. Economists hold the view that this would increase their savings more than their immediate consumption. Quite understandably, if you find twice the money you were earning a few days before then you would immediately think of saving a huge portion of it for the rainy day as well. Now this would increase the deposits at banks and Bank of England to a huge extent. Now banks do not love to keep all the possible money with them since there is a cost associated with keeping that money, which is paid in form interest to the lenders. Bank of England would discourage this over-saving of people by decreasing the interest rate and forcing them to invest this money rather than keeping it in banks. Moreover, usually closed economies know the fact that they would not witness any foreign investment and whatever investment would come, has to be from the strong public sector and the “public sector supported private sector” (Bosworth, pp. 15-41, 1993). Usually they increase the money supply to help people invest more thus making the private sector active. Therefore, the Bank of England has to decrease the interest rates to balance investment from the private sector as well. Now the next discussion is regarding the effect on the “level of output” of this decision. As the graph shows that increasing the money supply would force the LM curve to shift towards the right. Now this shift, quite clearly, decreases the interest rates, as discussed above and in turn, increases the output. Now this increase in output is due to many reasons (Abel & Bernanke, pp. 359-394, 2001). Firstly, as mentioned above, that when people find themselves with more money, they would obviously spend a significant portion of it thus increasing the aggregate output and income level of the economy. Moreover, lower interest rates would force the consumers to invest their money rather than holding. Quite understandably, investment creates employment, which creates income and which in turn increases the output of the economy. (Kassam, 2006) Lastly, we will take about its effect on the price level of this economy where prices and wages are fully flexible. According to the quantity theory of money: M*ΰ = P*Y Where M = money supply ϋ = Velocity P = Price level Y = Output Very important to note here is that we are assuming the velocity with which the money would be spreading would remains constant because there is no foreign intervention and prices and wages are fully flexible. As discussed earlier, that with this step, the output has to increase but since Velocity is constant, therefore it means that the price level and output would have to absorb the increase completely. Therefore, for example, if the money supply increases by 100 percent and it increases the output by 50 percent then the price level would rise by 50 percent (Dornbusch, pp. 128-134, 2006). There is even another way of looking at it. A closed economy is at a larger risk of inflation than an open economy. Consider the example of United States during the mid 20th century printed dollar like anything, which is a record in the history. However, it did not increase inflation because of the fact that US spend it all outside their border for financing wars, paying to politicians, secret agencies, spies and others. However, since the spent all this aboard there was no inflation at all at home (Hillier, pp. 630-654, 1991). The same is true for other countries if they print currency notes for spending outside or if the new money largely goes outside the home country. This way the inflation would not raise that much as it should. However, for a closed economy this option is not there since all the money would remain at home thus increasing the inflation or price level. B. An increase in the willingness to work Willingness to work actually here refers to employment. Without any doubts, the level of employment and unemployment is very much crucial for a country since it affects many macroeconomic variables. An increase in the willingness to work means that the employment rate of the economy is increasing. Usually closed economies witness this situation when they undergo an economic boom. Firstly, the affect of increase in employment rate on the level of output is even simple enough to understand for even a nonprofessional. When more individuals would work more, obviously they would contribute more to nation’s total Gross domestic product. Therefore, it would increase the aggregate output or income of economy. However, it is important here to note since it is a closed economy, the new people who are willing to work would have to work within the country and the increase in willingness would be equal to the new labor hired and the increase in output as well (Sayer, pp. 396-423, 1982). Secondly, we have to task to understand the affect on the general price level. Concisely, increasing employment would decrease the price level or inflation. We will attempt to understand the same with the help of the graph presented below. In the graph, the market is currently in equilibrium. The new people that are willing to work would push the supply curve for labor towards the right thus forcing the equilibrium labor wages to decrease. A decrease in labor wage rate means a decrease in cost of production, which in turn means lower price charged for the finished goods. These lowered prices would effect inflation and decrease the general price level (Razin, Yuen & National Bureau of Economic Research, pp. 236-259, 2001). Lastly, we have to analyze the relationship of high employment rate with interest rates. In a closed economy, generally, high employment would mean that people would be spending more. In addition, a decrease in the general price level implies that people would have more income left after spending on their projected expenses. Therefore, they would automatically prefer going to banks for making deposits. However, bank would take the advantage since it knows that during this period of excess demand of funds, people would even prefer to make deposits with lesser interest rate. Therefore, the interest rates would go down due to excess funds and general increase in the price level (Abel & Bernanke, pp. 359-394, 2001). C. A fall in the average propensity to save According to the very basic model of the Keynesian economics, income is equal to consumption and savings. Moreover, for an economy in equilibrium, savings would equal to investment (Dornbusch, pp. 128-134, 2006). Firstly, we would look into the relationship of decreased savings with the level of output for a closed economy. Experts (Mankiw, pp. 289-299, 2007) are of the views that for a closed economy decrease in average propensity to save means that the consumer is now spending the same portion of his income, which he used to save. Higher levels of spending quite understandably increase the aggregate output of the economy. Moreover, in special cases this decrease in saving behavior may also mean that the people are more interested towards investing the money in the country due to some unusual investment opportunities. However, the latter paragraphs discussing the relationship of interest rates and decreased savings reveal a contradicting story. Since interest rates increase due to decreased savings, it leads to dampened economic growth. Therefore, there is also some evidence to believe that the output would decrease due to decreased savings (Mankiw, pp. 289-299, 2007). Decreased savings have all the potential to increase the interest rates of the economy. In any closed economy savings from common people, remains one of the most important and crucial ways of financing investment. An unusual decrease in the savings would leave the market forces of the closed economy with lesser money to finance the investments. Therefore, the Bank of England would have to encourage people to come back on the saving track. Quite understandably, Bank of England would have to increase the return on investment for putting the money in banks. In other words, the Bank of England would have to increase the interest rates to force people to put their money in the banks once again (Bosworth, pp. 15-41, 1993). Lastly, it is the relationship of decreased savings with the general price level, which has to come under discussion. There is pretty much evidence to believe that a decrease in average propensity to save in a closed economy would lead to increased price level. Firstly, decreased savings would lead to a gap for financing investment thus hampering investment. Moreover, even with high interest rates, the cost of investment would increase which would increase the cost of production and in turn the prices of the produced products (Mankiw, pp. 289-299). Secondly, decreased savings indicate that the consumers are spending more than normal. This excess spending have the potential to increase the prices of products thus increasing the price level. Conclusion At the end of this paper, we are in a position to conclude that all the above-mentioned actions would have a considerable effect on any closed economy. Moreover, the lesson here is that all these actions would have to be accompanied with adequate monetary and fiscal policy changes in order to minimize the negative consequences and balance the overall scenario. No economic policy or activity can take place in isolation and the same is true for the remedies or the results of these economic policies or happenings. For example, doubling in the nominal quantity of money would increase the money supply and the Bank of England would have to enter into open market operation for coping with the risk of inflation. An increase in the willingness to work would end up brining the interest rates and the general price level down. Moreover, if people leave saving then it would decrease the level of output, increase the rate of interest and increase the general price level. References Abel, Andrew B., & Bernanke, Ben. (2001). Macroeconomics. Addison-Wesley. Baumol, William J., & Blinder, Alan S. (2007). Macroeconomics: Principles and Policy. Cengage Learning. Bosworth, Barry. (1993). saving and investment in a global economy. Brookings Institution Press. Dornbusch, Rudiger. (2006). Macroeconomics. McGraw-Hill Australia. GCSE economics. (2008). How we work: wages and salaries. Retrieved on March 14, 2010. Retrieved from http://tutor2u.net/economics/gcse/revision_notes/work_wages_salaries.htm Hillier, Brian. (1991). The macroeconomic debate: models of the closed and open economy. Wiley-Blackwell. Kassam, Fatima B. (2006). The Case for Cash. BC Journal of International affairs. Retrieved on March 14, 2010. Retrieved on March 12, 2010: http://bcjournal.org/2006/the-case-for-cash/ Library of Congress. (2009). North Korea: A Country Study. Library of Congress. Mankiw, N. Gregory. (2007). Principles of economics. Cengage Learning. Monetary Freedom. (2009). Interest Rates and “Tight” Money. Retrieved on March 14, 2010. Retrieved from http://images.google.com.pk/imgres?imgurl=http://1.bp.blogspot.com/_5uwdL2ImoZQ/Sw0-7j5HFSI/AAAAAAAAAIA/u56j6hub54c/s1600/keynesian%2Bmoney%2Bmarket.bmp&imgrefurl=http://monetaryfreedom-billwoolsey.blogspot.com/2009/11/interest-rates-and-tight-money.html&usg=__NfTEh20-N_Zn6-YSuuvAJL6b5Fo=&h=449&w=693&sz=14&hl=en&start=2&um=1&itbs=1&tbnid=BSO3ac7JsznOuM:&tbnh=90&tbnw=139&prev=/images%3Fq%3Dquantity%2Bof%2Bmoney%26um%3D1%26hl%3Den%26rlz%3D1R2ADFA_enPK355%26tbs%3Disch:1 Razin, Assaf, Yuen, Chi-Wa., & National Bureau of Economic Research. (2001). The "new Keynesian" Phillips curve: closed economy vs. open economy. National Bureau of Economic Research. Sayer, Stuart. (1982). An introduction to macroeconomic policy. Butterworth Scientific. Walters, Tara. (2008). North Korea. CHILDRENS PR. Read More