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Chapter 11 Basic Determinants of Exports and Imports.

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1 Chapter 11 Basic Determinants of Exports and Imports

2 The Importance of Foreign Trade The fundamental identity C + I + F + G = GDP has been used as a foundation for explaining GDP. Implicit in this equation is the statement that a rise in F translates into an equal increase in GDP, so if exports rise, the economy expands, and if imports rise, the economy contracts. That simply is not true – especially for the U.S., because the world is on a de facto dollar standard. Even for other countries, a rise in exports, or a drop in imports, may not boost real GDP.

3 The Importance of Foreign Trade, Slide 2 In the long run, the impact of changes in foreign trade on aggregate demand are minimal. Instead, the major relationship occurs on the supply side: increasing foreign trade boosts total GDP and productivity. There are three main reasons for this. First, comparative advantage means each country produces goods in which they are relatively efficient. Second, foreign trade helps to keep inflation low and stable. Third, when imports rise in countries with major currencies, inflows of foreign saving increase, boosting investment.

4 Current and Capital Account In every country, the current account balance – which is essentially net exports in goods and services – is the same as the capital account – which is essentially the net flow of capital – with the opposite sign. For example, if U.S. imports rise, the extra dollars received abroad eventually make their way back to the U.S., where it is reinvested.

5 Current and Capital Accounts, Slide 2 Of course, there are some caveats. If too few investors want to hold dollars, the value of the currency sinks below equilibrium and the advantages of foreign trade are partially undone. For small countries with rudimentary central banks, few investors want to hold their currency, so it must be converted into dollars or other strong currencies – which may not be available. Thus most countries cannot have their imports exceed their exports for very long. However, since the world is on a de facto dollar standard, that does not apply to the U.S.

6 Balance of Payments Mechanisms In the old days, countries could demand settlement of their international balances in gold. However, since the U.S. went off the International Gold Standard in August 1971, that is no longer an option. Accounts are settled through foreign exchange markets. As long as foreign investors are willing to hold more dollars (or sterling, euros, or yen) without depressing the value of the currency, a trade deficit does not have a negative impact on the economy. If investors not wish to hold as many dollars et al, the value of the currency sinks in forex markets until a new equilibrium level is reached.

7 Equilibrium Value of Currency There is no longer any set value for any currency. In economic terms, however, a currency is near its equilibrium value when the cost of producing a trade-weighted average of the market basket of traded goods is the same for all countries. In somewhat simpler terms, equilibrium means firms are facing a level playing field with foreign competitors. This does not mean that all firms and industries can compete equally, but that on average they are able to compete fairly.

8 Effect of Foreign Trade on GDP An individual firm or industry will benefit when its exports increase, and suffer when competitive imports increase. Yet for the U.S. economy as a whole, the growth rate is higher during times when the trade balance is negative or the trade deficit is rising, and lower when the trade balance is positive or the deficit is shrinking.

9 Effect of Foreign Trade on GDP, Slide 2 To a certain extent, a change in net exports is just a wash. For example, if imports rise, the increase in foreign capital inflows often means that capital spending rises more rapidly because of increased foreign investment? However, foreign trade is a wash only on the demand side. On the supply side, increased capital spending boosts productivity and expands total capacity, and increased foreign trade also boosts quality and productivity.

10 Effect of Foreign Trade on GDP, Slide 3 Remember, this only works if the dollar and other currencies remain near purchasing power parity. If the dollar is overvalued relative to foreign currencies, the deficit can then become large enough that U.S. real growth would be reduced. But if that happened, the value of the dollar would eventually decline, because foreign investors would no longer be as interested in investing in U.S. assets, and it would return to equilibrium.

11 Effect of Foreign Trade on GDP, Slide 4 But what about good jobs at good wages? If high-wage manufacturing jobs disappear overseas and are replaced by low-wage service jobs, how does that benefit the U.S. economy? For one thing, goods are cheaper. There are fewer low-tech jobs, but more high-tech jobs, in the U.S. Most of the losses in manufacturing employment in recent years have occurred in low-paid mfg jobs, such as textiles and apparel.

12 Differences in Trade Patterns Since the end of the international gold standard in 1971, the U.S. has always had a surplus in capital goods and a deficit in consumer goods. The deficit in consumer goods increased sharply after the start of NAFTA in The biggest deficits are in motor vehicles, textiles and apparel, and energy.

13 Determinants of Imports The change in imports is closely related to the growth rate in the U.S. economy. The elasticity is greater than unity, so a boom results in a more than proportionate increase in imports. To a certain extent, imports are negatively related to the value of the dollar. However, the elasticity is fairly small because most foreign producers adjust their prices to domestic levels. Thus, for example, when the dollar strengthened, foreign car producers do not boost their prices proportionately.

14 Determinants of Exports To a certain extent, the change on exports depends on the growth rate in the rest of the world. However, that growth rate is not independent of what happens in the U.S. In particular, a boom this year is likely to be followed by faster growth abroad next year, while a recession this year is likely to be followed by a slowdown abroad next year. As a result, exports are correlated with the change in domestic economic activity lagged one year. This is known as the repercussion effect. Also, exports are negatively correlated with the value of the dollar; the price elasticity is somewhat greater than for imports.

15 How Serious is the Trade Deficit? Unlike the Federal budget deficit, which depends on the phase of the business cycle and can be cured with rapid growth, the trade deficit appears to be permanent. Furthermore, the faster the U.S. economy grows, the larger the trade deficit, cet. par. What are the plusses and minuses of an ever-increasing trade deficit?

16 Benefits of a Bigger Trade Deficit Consumers get a larger variety, better quality, and lower prices for traded goods. The same general comments also apply to capital goods. Vigorous foreign competition boosts productivity and reduces inflation, which also keeps interest rates low Increase in foreign saving helps to fund capital spending and boosts financial market prices

17 Disadvantages of a Bigger Trade Deficit Loss of manufacturing jobs Some industries may be completely shut down, leaving the U.S. to depend entirely on foreign sources. However, these may still be owned by U.S. investors. Most serious, if the trade deficit becomes so large that the value of the dollar falls below equilibrium, then the advantages of vigorous productivity growth and low inflation start to disappear.

18 What About Increased Foreign Ownership of U.S. Assets It is sometimes claimed that increased foreign ownership of U.S. assets will cause the returns from capital to flow to other countries, saddling the U.S. with an ever- increasing foreign debt. However, the argument here is basically the same as for the trade deficit. As long as the funds are reinvested in the U.S., foreign ownership doesnt matter. Only if the dollar falls below equilibrium do the disadvantages of foreign ownership become serious. That can be avoided by implementing pro-growth fiscal and monetary policies that will continue to attract more foreign investment.

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