How Closing International Borders Harms an Economy, and Why Different Countries Choose Different Policies

Answer

Part (a)

Closing international borders harms an economy through two distinct channels — it lowers aggregate demand and it lowers aggregate supply — producing both negative actual growth and cost-push inflation.

Fall in aggregate demand. With $AD = C + I + G + (X-M)$, border closure lowers net exports and investment. For a tourism-reliant economy like Singapore, inbound tourism is a services export: closing borders cuts tourist arrivals, lowering export revenue $X$ directly. Closure also disrupts supply chains, reducing the volume of traded goods. And the anticipation of higher wage costs and a worse business outlook deters foreign direct investment and domestic investment, lowering $I$. The fall in $(X-M)$ and $I$ shifts AD leftward, and through the reverse multiplier lowers national income more than proportionately, raising demand-deficient unemployment.

Fall in aggregate supply. Border closure raises unit costs of production and can lower productive capacity. Supply-chain disruption makes imported raw materials scarcer and dearer — costly for a resource-poor economy like Singapore — raising unit costs. Closing the border to foreign workers (e.g. from Malaysia) creates a sudden labour shortage that bids up wages, again raising unit costs and shifting SRAS leftward; if prolonged, the loss of labour shrinks productive capacity and shifts LRAS leftward too.

The fall in AD lowers output and employment; the fall in SRAS raises the general price level as firms pass higher unit costs into prices. Together they produce negative actual growth alongside cost-push inflation — the adverse outcome. The severity depends on the initial state of the economy and the size of the cost increase.

Part (b)

Different countries face different mixes of the two consequences — negative growth versus cost-push inflation — and differ in the effectiveness of each instrument, so they rationally choose different policies. My thesis is that policy choice is governed by the nature of the economy (size of the domestic sector, openness, fiscal space) and the dominant consequence each country faces.

A country may use expansionary demand-management. To counter negative growth, a country can use expansionary fiscal policy — cutting income tax to raise $C$, cutting corporate tax to raise $I$, and raising government spending $G$ — lifting AD through the multiplier.

Evaluation. The effect on $C$ and $I$ depends on expectations: if the outlook is bleak, households and firms withhold spending, so stimulus works best for a country with a large domestic sector (the US), where movements in $C$, $I$, $G$ move GDP substantially. It is also limited by fiscal space — borrowing to fund a deficit can crowd out private spending by raising interest rates, so a country with a tight budget cannot lean on it.

Another country may use supply-side or exchange-rate policy. A country whose dominant problem is cost-push inflation, or which is small and open, will favour different tools. A small, import-reliant, export-oriented economy like Singapore — where demand-management is weak because $C$ and $I$ are a small share of AD and the multiplier is small — uses exchange-rate policy, appreciating its currency to lower imported input costs and ease cost-push inflation, and supply-side policy to raise domestic capacity and reduce reliance on disrupted imports.

Evaluation. Appreciation risks weakening export competitiveness (lowering net exports if Marshall-Lerner holds), and supply-side measures act with a long time lag, so neither is costless.

Judgement. Countries adopt different policies because their economies differ in structure and in the balance of consequences they face. A large, relatively closed economy with fiscal space leans on expansionary fiscal policy to fight the demand collapse; a small, open, import-reliant economy leans on exchange-rate and supply-side policy to fight cost-push inflation and build resilience, because demand-management is comparatively ineffective for it. The right policy is therefore not universal but conditional: it is the instrument matched to the economy’s structure and to whichever of negative growth or cost-push inflation is the binding constraint. In practice most countries combine instruments, weighting the mix toward their particular vulnerability.