Net Exports and International Finance

Read this chapter to examine the reasons nations trade and the way net exports determinants influence aggregate demand and the equilibrium GDP and price level in a country. Also, learn about the balance of payments components and the way financial capital flows mirror the trade balance. The chaper also defines and compares various types of exchnage rate systems.

1. The International Sector: An Introduction

The Rising Importance of International Trade

International trade is important, and its importance is increasing. For example, from 1990 to 2010, world output growth was about 3% per year on average, while world export growth averaged about 6% per year.

While international trade was rising around the world, it was playing a more significant role in the United States as well. In 1960, exports represented just 3.5% of real GDP; by 2011, exports accounted for more than 13% of real GDP. Figure 15.1 "U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2011" shows the growth in exports and imports as a percentage of real GDP in the United States from 1960 to 2011.

Why has world trade risen so spectacularly? Two factors have been important. First, advances in transportation and communication have dramatically reduced the costs of moving goods around the globe. The development of shipping containerization that allows cargo to be moved seamlessly from trucks or trains to ships, which began in 1956, drastically reduced the cost of moving goods around the world, by as much as 90%. As a result, the numbers of container ships and their capacities have markedly increased. For an interesting history of this remarkable development, see Marc Levinson, The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger. Second, we have already seen that trade barriers between countries have fallen and are likely to continue to fall.

Figure 15.1 U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2011

Chart

The chart shows exports and imports as a percentage of real GDP from 1960 through 2011.


Net Exports and the Economy

As trade has become more important worldwide, exports and imports have assumed increased importance in nearly every country on the planet. We have already discussed the increased shares of U.S. real GDP represented by exports and by imports. We will find in this section that the economy both influences, and is influenced by, net exports. First, we will examine the determinants of net exports and then discuss the ways in which net exports affect aggregate demand.


Determinants of Net Exports

Net exports equal exports minus imports. Many of the same forces affect both exports and imports, albeit in different ways.


Income

As incomes in other nations rise, the people of those nations will be able to buy more goods and services - including foreign goods and services. Any one country's exports thus will increase as incomes rise in other countries and will fall as incomes drop in other countries.

A nation's own level of income affects its imports the same way it affects consumption. As consumers have more income, they will buy more goods and services. Because some of those goods and services are produced in other nations, imports will rise. An increase in real GDP thus boosts imports; a reduction in real GDP reduces imports. Figure 15.2 "U.S. Real GDP and Imports, 1960–2011" shows the relationship between real GDP and the real level of import spending in the United States from 1960 through 2011. Notice that the observations lie close to a straight line one could draw through them and resemble a consumption function.

Figure 15.2 U.S. Real GDP and Imports, 1960–2011

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The chart shows annual values of U.S. real imports and real GDP from 1960 through 2011. The observations lie quite close to a straight line.


Relative Prices

A change in the price level within a nation simultaneously affects exports and imports. A higher price level in the United States, for example, makes U.S. exports more expensive for foreigners and thus tends to reduce exports. At the same time, a higher price level in the United States makes foreign goods and services relatively more attractive to U.S. buyers and thus increases imports. A higher price level therefore reduces net exports. A lower price level encourages exports and reduces imports, increasing net exports. As we saw in the chapter that introduced the aggregate demand and supply model, the negative relationship between net exports and the price level is called the international trade effect and is one reason for the negative slope of the aggregate demand curve.


The Exchange Rate

The purchase of U.S. goods and services by foreign buyers generally requires the purchase of dollars, because U.S. suppliers want to be paid in their own currency. Similarly, purchases of foreign goods and services by U.S. buyers generally require the purchase of foreign currencies, because foreign suppliers want to be paid in their own currencies. An increase in the exchange rate means foreigners must pay more for dollars, and must thus pay more for U.S. goods and services. It therefore reduces U.S. exports. At the same time, a higher exchange rate means that a dollar buys more foreign currency. That makes foreign goods and services cheaper for U.S. buyers, so imports are likely to rise. An increase in the exchange rate should thus tend to reduce net exports. A reduction in the exchange rate should increase net exports.


Trade Policies

A country's exports depend on its own trade policies as well as the trade policies of other countries. A country may be able to increase its exports by providing some form of government assistance (such as special tax considerations for companies that export goods and services, government promotional efforts, assistance with research, or subsidies). A country's exports are also affected by the degree to which other countries restrict or encourage imports. The United States, for example, has sought changes in Japanese policies toward products such as U.S.-grown rice. Japan banned rice imports in the past, arguing it needed to protect its own producers. That has been a costly strategy; consumers in Japan typically pay as much as 10 times the price consumers in the United States pay for rice. Japan has given in to pressure from the United States and other nations to end its ban on foreign rice as part of the GATT accord. That will increase U.S. exports and lower rice prices in Japan.

Similarly, a country's imports are affected by its trade policies and by the policies of its trading partners. A country can limit its imports of some goods and services by imposing tariffs or quotas on them - it may even ban the importation of some items. If foreign governments subsidize the manufacture of a particular good, then domestic imports of the good might increase. For example, if the governments of countries trading with the United States were to subsidize the production of steel, then U.S. companies would find it cheaper to purchase steel from abroad than at home, increasing U.S. imports of steel.


Preferences and Technology

Consumer preferences are one determinant of the consumption of any good or service; a shift in preferences for a foreign-produced good will affect the level of imports of that good. The preference among the French for movies and music produced in the United States has boosted French imports of these services. Indeed, the shift in French preferences has been so strong that the government of France, claiming a threat to its cultural heritage, has restricted the showing of films produced in the United States. French radio stations are fined if more than 40% of the music they play is from "foreign" (in most cases, U.S.) rock groups.

Changes in technology can affect the kinds of capital firms import. Technological changes have changed production worldwide toward the application of computers to manufacturing processes, for example. This has led to increased demand for high-tech capital equipment, a sector in which the United States has a comparative advantage and tends to dominate world production. This has boosted net exports in the United States.


Net Exports and Aggregate Demand

Net exports affect both the slope and the position of the aggregate demand curve. A change in the price level causes a change in net exports that moves the economy along its aggregate demand curve. This is the international trade effect. A change in net exports produced by one of the other determinants of net exports listed above (incomes and price levels in other nations, the exchange rate, trade policies, and preferences and technology) will shift the aggregate demand curve. The magnitude of this shift equals the change in net exports times the multiplier, as shown in Figure 15.3 "Changes in Net Exports and Aggregate Demand". Panel (a) shows an increase in net exports; Panel (b) shows a reduction. In both cases, the aggregate demand curve shifts by the multiplier times the initial change in net exports, provided there is no other change in the other components of aggregate demand.

Figure 15.3 Changes in Net Exports and Aggregate Demand

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In Panel (a), an increase in net exports shifts the aggregate demand curve to the right by an amount equal to the multiplier times the initial change in net exports. In Panel (b), an equal reduction in net exports shifts the aggregate demand curve to the left by the same amount.

Changes in net exports that shift the aggregate demand curve can have a significant impact on the economy. The United States, for example, experienced a slowdown in the rate of increase in real GDP in the second and third quarters of 1998 - virtually all of this slowing was the result of a reduction in net exports caused by recessions that staggered economies throughout Asia. The Asian slide reduced incomes there and thus reduced Asian demand for U.S. goods and services. We will see in the next section another mechanism through which difficulties in other nations can cause changes in a nation's net exports and its level of real GDP in the short run.