Closed and Open Economic Systems

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The Closed System:

A closed system is a purely theoretical model of a system of production that takes nothing from without and adds nothing to the external world. Another way of defining it is to consider a system where the positive flows and negative charges cancel each other out. It is closed in that all flows refer only to themselves. They must cancel each other out to avoid either surpluses or deficits. Deficits in particular could not be enclosed since eventually, they would have to be compensated for externally. Deficits would take from one aspect of production or another until that sector no longer functioned. Balance is the key to a closed system.

The simplest flow in a closed system would be between firms and households. Firms produce the goods, the goods are bought, the money flows back to firms so as to produce more goods. More realistically, the state both adds and subtracts value from both. Even more realistically, savings (or the financial sector), plus investment (that is, capital goods) are also part of a closed system in theory.

The inner flow of a closed system is often depicted as comprising both savings and investment. These are more "macro" than buying and selling, since they are the conditions of both. Savings and investment are both voluntary (where taxes are not) and hence, savings is needed for the creation of capital that can create better and more useful products to be bought and sold.

The outer flow is again, the simple buying and selling between firms and households. The state is involved in both flows. Capital is taxed (i.e. production is taxed, regardless of who ends up paying it), savings is (or can be) taxed, since interest here is considered income unless it is a special account like a HSA.

The state is the anomalous force in the closed system. It is the only non-voluntary aspect of it. It can add value through subsidies (so long as they are used properly) but also removed value form taxation. With no friction, taxes and subsidies (speaking broadly) should balance each other out. But we're not idiots.

Such a system is closed because, in its theoretical and imaginary guise, it requires no outside forces to make it work. Technically, such a system can be erected and maintained, though the state sector would be monstrous to enforce it (and in which case, would probably be considered a form of leakage, or at least, inefficiency). Examples of almost totally enclosed economies might be medieval China or modern North Korea, but even these two examples were not immune to global trade flows or even public opinion. Stalin tried to create a purely autarkic economy in the USSR, but was unable to do so since US aid to the "communist enemy" was far to important. Pol Pot also through Cambodia could be totally closed, but he did not rule long enough to see it occur.

The Open System:
An open economy is more realistic since it is exposed to benefits and problems that originate outside of itself. Speaking generally, a closed economy would be one on a national or regional level. The open economy might be more global or continental. There is no ...