Net export spending
'Net' exports refer to the value of a country's export earnings from the sale of goods and service abroad, minus its expenditure on imports of goods and services.
Net exports form a key component of the aggregate demand equation:
AD = C + I + G + (X - M)
X and M as values
Positive net exports are an injection
If net exports are positive, then it represents an injection into the circular flow of income. However, if import spending is greater than export earnings, net exports are negative, and the effect is that spending leaks out of the circular flow of income.
Factors affecting net exports
Changes in national income
The simple model of trade identifies how exports (X) and imports (M) change when real national income (Y) changes. Exports are assumed to be exogenous - that is, determined 'outside' of the model and not determined by a country's current real income (Y). However, import spending is determined by changes in Y - which is ‘within’ the model.
Changes in national income are, perhaps, the most important factor affecting imports, and this relationship must be understood before considering other factors.
The cross diagram
The ‘cross’ diagram provides a graphical analysis of the basic trade model, and is a convenient way to show the impact of a change in income (real GDP) on trade. The cross diagram compares how imports and exports change when national income changes. Consider the schedule below for a hypothetical economy (Table 1):
In this example, trade balances (X=M) at the level of income (Y) of $100bn. An increase in national income will result in an increase in imports. For example, if Y increases to $120bn, imports will rise to $65bn, with exports unchanged. This will create a trade deficit of $5bn at this new income.
Of course, when Y falls, net exports tends to move towards a surplus, as in the example - when Y falls to $80, imports fall to $55bn. This creates a trade surplus of $5bn.
Exports will be left unaffected in the current time period as they depend upon changes in foreign income, along with other exogenous factors. Hence there is a tendency for net exports to move towards a deficit during a period of domestic growth. Hence, a large or rising deficit could be a sign of an 'over-heated' domestic economy.
The gradient of the import line is the marginal propensity to import (mpm), which is ΔM/ΔY. In this case, the mpm is 5/20 = 0.25.
Read more on marginal propensities.
Exchange rates
Both import spending and export revenue are affected by changes in exchange rates.
An increase in a country's exchange rate will, potentially, raise the prices of its exports abroad. For example, an increase in the exchange rate of GB pounds to US dollars [from £1=$1.20, to £1=$1.40] is likely to raise the price of UK exports in the US, assuming the new exchange rate passes through to prices in the US. If it does, the higher price in the US will cause a contraction of demand, as shown.
An increase in the exchange rate will mean that import prices are likely to fall, resulting in an increase in demand for imports. However, this will not necessarily increase or decrease the value of exports and imports (and net exports) given that it depends on the price elasticity of demand for imports and exports.
The effect of a change in the exchange rate and price elasticity of demand
We can see in the diagram that the impact of an increase in the sterling exchange rate depends upon price elasticity of demand for imports and exports.
The more elastic the demand the more likely a change in the exchange rate will affect the value of net exports. It also depends on whether the increase in the exchange rate is passed through to cheaper import prices. On this point, given that exchange rates can be volatile, producers may prefer not to alter prices and adopt a longer term view.
For a detailed explanation, go to the Marshall-Lerner condition.
Interest rates
Interest rates can influence net export demand in several ways.
Firstly, interest rates can affect household spending and investment spending, and therefore affect aggregate demand. Assuming aggregate supply is relatively elastic, increases in aggregate demand can raise equilibrium GDP, which in turn can increase demand for imports - given that import demand is a function of national income [m=fY].
Secondly, interest rates affect the flow of funds into an economy to purchase financial assets. If the interest rate in an economy increases relative to other rates, international fund holders can transfer funds in the expectation of making a short term gain. The significant point here is that it is 'real' interest rates that influence decisions to speculate, and hence the rate of inflation is also a factor in influencing financial flows. These 'interest rate sensitive' flows are referred to as 'hot money'.
Relative inflation
Relative inflation will affect both import and export demand. If a country experiences a period of inflation its exports are likely to suffer, and it is likely to increase demand for relatively cheaper imports. As with the effect of exchange rates changes, the impact will depend upon relative price elasticities of demand.
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Productivity levels in an economy (compared with other countries)
Productivity refers to how well scarce resources are being used. It is usually calculated as output per person or output per hour worked. Changes in productivity relative to other countries can affect trade flows. Improvements in productivity will increase the competitiveness of exports, as well as make domestically produced good more attractive to domestic consumers, which may limit imports. Productivity could be improved by a combination of schemes and policies, including:
• Better use of efficient technology
• More highly skilled workforce
• An effective education system
• Better infrastructure
• Increased labour mobility
• Increased labour flexibility
• Fewer restrictive practices in the labour market (e.g. reducing the power of trade unions)
Trade barriers
Trade barriers, including quotas and tariffs, can limit the openness of an economy, and result in a reduction in trade. This may increase or decrease net exports depending on the relative strength of the barriers that exist, and the type of barrier.
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Membership of trading blocs
Countries may not be able to adjust their trade policy because they are in a regional trading bloc (RTB), such as the European Union (EU). This may mean that they cannot put up barriers to other members of the trading bloc. Also, if countries are in a monetary union (such as the Eurozone) they cannot alter interest rates because they will be set by the monetary union’s central bank (which is the European Central Bank (ECB) in the case of the Eurozone.)
Export subsidies
Export subsidies are a type of trade barrier but require a special mention. By subsidising exports, export price falls and exporters can derive a short-term advantage in terms of price competitiveness. If this results in import penetration such subsidies can also provide a long-term advantage.
However, countries may retaliate, or indeed may not be allowed to provide state aid if they are a member of a trading bloc, such as the EU which has rules limiting state aid by its members.
Of course, the trading bloc as a whole may support its industries with subsidies. This appears to be the case with the EU aviation sector which is heavily subsidised - prior to the additional subsidies to deal with the fall-out from the COVID-19 pandemic.
Net exports can be affected by several factors, including:
The attractiveness of exports and imports - non-price factors
Exchange rates and relative inflation affect the prices of imports and exports. However, domestic and overseas consumers do not purchase goods and services just because goods are cheap. Non-price factors also affect trade (and net exports), including:
• The quality of goods and services
• The reliability and availability of goods and services
• The reputation of exported (and imported goods)
• The impact of strong branding (of domestic and imported goods)
• The expectation of ‘after sales’ servicing’ – e.g. are parts and components available
The effect of an increase in net exports
An increase in net exports will shift the aggregate demand curve to the right.
If this happens the effect in the next time period is that exports (X) may decrease, and imports (M) increase. To some extent short term deficits and surpluses are self-correcting. A rise in GDP caused by an increase in net exports will bring the trade balance back towards equilibrium as a result of the rise in the level of prices, and the rise in imports as a result of growth.
The self-correcting nature of trade imbalances is one reason why many economists do not favour aggressive interventions to try to engineer a trade balance.
Expenditure reducing versus expenditure switching
Changes in income levels work as a result of a process called expenditure reduction. Less income means less imports.
Changes in other variables, such as the exchange rate and interest rates work by a process called expenditure switching – meaning that consumers in one country and in other countries ‘switch’ between buying domestic goods or buying imports.