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15 International
Trade, Capital
Flows and the
Exchange Rate
Chapter Outline
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From Blog 2 Nov External economy considerations – Part 1
15.1
Introduction
In Chapter 8, we introduced trade into the income-expenditure model. The representation was simplistic, in the
sense that we assumed that exports were determined by the income levels prevailing in the rest of the world (that
is, they were exogenous to the domestic economy) and that imports were a simple proportion of the national
income of the home economy. This proportion was termed the marginal propensity to import.
In this Chapter we extend our understanding of the way in which the economy behaves once it becomes open to
the world. We will continue to consider the price level to be fixed, which means we are assuming that firms
respond to an increase in aggregate demand by increasing real output. Later in the Chapter we will consider
price level movements in the open economy context.
We will consider the concept of an exchange rate and examine how movements in exchange rates influence
exports and imports and financial transactions between nations.
For an economy as a whole, imports are real goods and services coming into the nation from abroad and as such
represent a real benefit to residents. Conversely, exports are real goods and services that are sold to foreigners.
Exports represent a real cost to residents because they represent real resources (labour, capital and other
productive inputs) that the residents are unable to utilise themselves.
It is obvious that the only motivation for a nation to export, and incur the real costs involved in exporting goods
and services abroad, is to gain foreign currencies, which, in turn, allow the nation to purchase other goods and
services that it does not produce itself.
If imports exceed exports then a nation is able to enjoy a higher material living standard by consuming more
goods and services than it produces for foreign consumption. We will consider how this conception of trade
interacts with a flexible exchange rate.
You will already appreciate that the transactions between nations involve both real goods and services and
financial flows. The financial transactions represent currency flows in and out of a nation and have significant
implications for movements in the exchange rate and other macroeconomic aggregates, such as interest rates, the
inflation rate and real GDP.
All transactions between a nation and the rest of the world are recorded in the Balance of Payments. We will
initially examine the way the national statistician accounts for the external economy via the Balance of
Payments, which is a framework that is closely related to the National Accounts.
15.2
The Balance of Payments
National Statistical agencies regularly publish statistics relating to a nation’s economic interaction with the rest
of the world using what is known as the balance of payments and international investment position framework.
While there are variations in terminology used by different nations, the principles are universal. Most nations
use the International Monetary Funds’s Balance of Payments and International Investment Position Manual
http://www.imf.org/external/pubs/ft/bop/2007/pdf/bpm6.pdf (BPM6), augmented by the System of National
Accounts 2008 (2008 SNA), “as the standard framework for statistics on the transactions and positions between
an economy and the rest of the world” (IMF, 2011: 1).
The IMF define the balance of payments as:
… a statistical statement that summarizes transactions between residents and nonresidents during
a period. It consists of the goods and services account, the primary income account, the secondary
income account, the capital account, and the financial account.
The differentiating feature of these different accounts relates to “the nature of the economic resources provided
and received” by the nation (IMF, 2011: 9).
The Current Account (IMF, 2011: 9):
… shows flows of goods, services, primary income, and secondary income between residents and
nonresidents.
The goods and services or balance of trade records “transactions in items that are outcomes of production
activities” (IMF, 2011: 149) and considers the exchanges between the local economy and the rest of the world.
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[NOTE THIS SECTION IS TO BE WRITTEN AND IS DESCRIPTIVE - IT OUTLINES THE BALANCE OF
PAYMENTS AND RELATED INTERNATIONAL ACCOUNTS]
Essential Concepts
Before we consider a more complex income and expenditure model (to incorporate exchange rates) we need to
understand the basic nomenclature.
The following essential concepts are used in open economy macroeconomics:

Nominal exchange rates

Foreign exchange markets

Exchange rate determination mechanisms – fixed and flexible

Real or effective exchange rates, unit labour costs and competitiveness
We will consider the history of exchange rate systems in a later section of this Chapter.
Nominal exchange rate (e)
The nominal exchange rate (e) is the number of units of one currency that can be purchased with one unit of
another currency. There are two ways in which we can quote a bi-lateral exchange rate. Consider the
relationship between the Australian dollar ($A) and the United States dollar ($US).

We might be interested in knowing the amount of Australian currency that is necessary to
purchase one unit of the US currency ($US1). In this case, the $US is what we call the
reference currency and the other currency is expressed in terms of how much of it is required
to buy one unit of the reference currency. So $A0.80 = $US1 means that it takes $0.80 (or 80
cents) of Australian currency to buy one $US.

Alternatively, e can be defined as the amount of US dollars that are needed to by one unit of
Australian currency ($A1). In this case, the $A is the reference currency. So, in the example
above, this is written as $US1.25= $A1. Thus if it takes $0.80 Australian to buy one $US, then
$US1.25 is required to buy one $A.
It is clear that the quotation under the first alternative with the US dollar as the reference currency is the inverse
of the second alternative. But to understand exchange rate quotations you must know which is the reference
currency. In this Chapter we use the first convention so e is the amount of domestic currency which is required
to buy one unit of the foreign currency.
e is the amount of $A which is required to buy one unit of the foreign currency
Change in e – appreciation and depreciation
Imagine that an Australian resident wishes to buy a product from a USA supplier who quotes the current US
price as $US40 and the $A-$US parity is current at $0.80. Then the equivalent Australian price is $A32
(multiply the foreign price by the nominal exchange rate). This situation is shown in the first row of Figure 15.1.
What happens if the nominal exchange rate falls to 0.70 (as shown in the second row of Figure 15.1)? This
means that instead of 80 cents Australian being required to purchase one $US only 70 cents Australian is
required.
So, a fall in e means that the $A has appreciated – it is worth more in terms of foreign reference currency. In the
example shown in Figure 15.1, this would mean that the price of the product from the USA would now be equal
to $A28 (0.7 times $US40).
Thus, even though the quoted US dollar price for the product remains unchanged, the local price equivalent is
now lower when the nominal exchange rate appreciates.
The example shows that an appreciation of the $A leads to:

Cheaper foreign goods in terms of $A and, other things being equal, this should lead to a rise
in the quantity of imports demanded.
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
Higher prices which foreigners will have to pay for our goods, and other things being equal,
this should lead to a fall in the quantity of imports demanded.
Now, assume that the Australian-USA parity rises from 0.80 to 0.90. This means that we now need 90 cents
Australian to purchase one $US. So, given our exchange rate definition, a rise in e means that the $A has
depreciated.
In the example shown in Table 15.1, this would mean that the price of the product from US would now be equal
to $A36 (0.9 times $US40).
The example shows that an depreciation of the $A leads to:

Foreign goods more expensive in terms of $A, and other things equal, this should lead to a fall
in the quantity of imports demanded.

The price foreigners have to pay for our goods lower, and other things equal, this should lead
to a rise in the quantity of exports demanded.
Table 15.1
Comparison of International Prices
e
$A to $US1
Foreign Price
$US
Local Price Equivalent
$A Change on Starting
Value
0.8
40
32
Starting value
0.7
40
28
Appreciation
0.9
40
36
Depreciation
What determines the exchange rate?
Exchange rates are determined by the supply of and the demand for currencies in the world foreign exchange
markets, which could be the local bank foreign currency desk or elsewhere, like a train station kiosk in a city
where travellers meet.
Sometimes we refer to foreign exchange in jargon as forex. The supply of and demand for currencies are in turn
linked to trade and capital flows between countries.
In Figure 15.2 we consider the foreign exchange market for the $A and the $US. In reality, many currencies are
traded in the foreign exchange market.
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Figure 15.1
A Simple Bi-lateral Foreign Exchange Market
$A per
$US1
Supply
Demand
Volume of $A
Consider the supply of Australian dollars to the foreign exchange market. When Australian residents buy
foreign goods (imports), buy foreign assets or lend abroad, they need to purchase the relevant foreign currencies
in which the transaction is denominated. To buy the currency they desire, they supply $As in exchange.
Alternatively, on the demand side, when foreigners buy Australian goods and services (exports) and/or
Australian financial assets they require $A. They purchase them in the forex market by supplying their own
currency in exchange.
Like any market determined price, e is in equilibrium when supply equals demand.
If there is an excess demand for $A then there is pressure for the $A to appreciate in price relative to other
currencies. As noted, an appreciation means that one unit of a foreign currency buys less $A, that is e declines.
If there is an excess supply of $A, the $A depreciates and one unit of foreign currency buys more $A, so e
increases.
These changes in e resolve the supply and demand imbalance. In the case of a depreciation in the Australian
dollar, the foreign price of Australian exports is now lower (less $US required to purchase a given $A priced
good), and with export demand varying inversely with price (by assumption), the demand for exports and hence
$A’s rises.
Assuming a fixed import price in the foreign currency, the $A price of imports has risen which reduces the
quantity demanded.
While most currencies float freely against each other, at times the central bank will enter the foreign exchange
markets as a buyer or seller of the local currency as a means of influencing the parity determined in that market.
This is called Official intervention and we will examine it in more detail later in the Chapter.
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What happens to the total $A value of imports when the exchange rate depreciates depends upon what
economists term the price elasticity of demand. An elasticity is the responsiveness in percentage terms of
quantity to price changes.
When demand falls less in percentage terms than the price rises, we consider the commodity to be inelastic.
Total revenue (or spending) will rise in this case.
When demand falls more in percentage terms than the price rises, we consider the commodity to be elastic.
Total revenue (or spending) will fall in this case.
When price and quantity change by the same proportion the commodity has a unitary elasticity and total revenue
(or spending) does not change.
Should the demand for imports be price inelastic (less than one), then the quantity demanded (volume) falls by a
smaller percentage than the $A rise in price and total import spending in $A would increase.
However, if the price elasticity of demand for imports is greater than one, then the percentage decline in demand
(volume) more than offsets the percentage gain in price and so total import spending in $A falls.
The circumstances under which the trade balance unambiguously improves following a depreciation is referred
to as the Marshall-Lerner Condition. It states that net exports will improve following a depreciation as long as
the sum of the export and import price elasticities exceeds unity. You do not have to learn the proof
underpinning this condition.
In summary, if the Marshall-Lerner condition is satisfied:

An excess supply of $A in the foreign exchange market leads to a depreciation in e and a rise
in net exports. This will reduce the excess supply of $A in the foreign exchange market.

An excess demand for $A in the foreign exchange market leads to an appreciation in e and a
decline in net exports. This will reduce the excess demand for $A in the foreign exchange
market.
Another component of the current account is net income, which results from the foreign ownership of domestic
assets and vice versa. We consider this component of the current account in more detail later in the Chapter.
This pattern of ownership of assets gives rise to a net flow of dividend and interest payments. If the net flow is
positive then national income rises, other things being equal. If the net flow is negative then national income
falls, other things being equal.
In Australia’s case, the net income flows on the current account are negative. In this case, a depreciation in the
$A can lead to a deterioration in net income because the interest payments or dividends may be denominated in
a foreign currency. The loss of income through this part of the current account may offset any gains that are
made as a result of depreciation on the trade balance.
For simplicity, we shall ignore the possible impact on net income and assume that through the satisfaction of the
Marshall-Lerner condition a depreciation of the domestic currency not only improves the trade balance,Th but
also the current account balance.
We can define three trade balance outcomes:

The trade balance is in deficit if the local currency value of its exports is less than the local
currency value of its import spending.

The trade balance is in surplus if the local currency value of its exports is greater than the
local currency value of its import spending.

The trade balance is in balance if the local currency value of its exports is equal to the local
currency value of its import spending.
Take Australia, as an example. A trade deficit for Australia means that increasing quantities of Australian
dollars are being accumulated by non-Australian residents. In return, the non-Australian residents have supplied
goods and services (imports) to Australian residents.
Clearly, the foreigners have allowed Australia to run a trade deficit because they preferred to accumulate
financial assets denominated in Australian dollars. The alternative would have been to spend the Australian
dollars they acquired through their exports to buy Australian goods and services (that is, to buy Australian
imports).
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Had the foreigners used their export income, which is denominated in $A to purchase other goods and services
from Australia, then there would have been a trade balance.
A trade deficit thus means that the foreigners are increasing their nominal savings (which in this case manifests
as Australian dollar denominated financial assets).
External economy considerations – Part 2
Posted on Friday, November 9, 2012 by bill
International Competitiveness
In the previous section we learned that an appreciation (depreciation) of a nation’s exchange rate leads to
foreign goods becoming cheaper (dearer) in terms of the local currency, which should lead to a rise (fall) in the
quantity of imports demanded, other things equal.
Further, an appreciation (depreciation) of a nation’s exchange rate means that foreigners have to pay higher
(lower) prices in their currency for locally-produced goods, which should lead to a rise (fall) in the quantity of
exports demanded, other things equal.
These conclusions, however, only focus on one element of the competitiveness of a nation’s goods and services
in international trade – the nominal exchange rate.
But to really answer the question – are local goods and services becoming more or less competitive with respect
to goods and services produced overseas we have to relax the “other things equal” assumption and consider the
domestic and foreign inflation rates.
This leads us to define a new concept – the real exchange rate which depends on two factors:

Movements in the nominal exchange rate, ee; and

Relative inflation rates (domestic and foreign).
There are also non-price dimensions to competitiveness, including quality and reliability of supply, which are
assumed to be constant at this stage.
We define the ratio of domestic prices (P) to the rest of the world (Pw) as Pw/P, which we call a relative price
because it expresses the foreign price level relative to the domestic price level. We assumed that Pw/P was
constant when we analysed movements in the nominal exchange rate in the previous section.
If the nominal exchange rate (e) is fixed, then we can conclude:

If Pw is rising faster than P, then local goods are becoming relatively cheaper than foreign
goods; and

If Pw is rising slower than P, then local goods are becoming relatively more expensive than
foreign goods.
The inverse of the relative price ratio, namely (P/Pw) measures the ratio of export prices to import prices and is
known as the terms of trade.
The Real Exchange Rate
Movements in the nominal exchange rate and/or the relative price level (Pw/P) provide information about
movements in the relative trading competitiveness between nations. The real exchange rate measures the
combined impact of these variables and is used to measure our competitiveness in international trade.
The real exchange rate (R) is defined as:
(15.1) R = (e.Pw/P)
where P is the domestic price level specified in local currency (say, $A), and Pw is the foreign price level
specified in foreign currency units (say $US).
The real exchange rate is the ratio of prices of goods abroad measured in $A (ePw) to the $A prices of goods at
home (P). So the real exchange rate, R adjusts the nominal exchange rate, e for the relative price levels.
To understand this better consider the following example. Assume that P = $A8 and Pw = $US10, and e = 0.8.
Remember a quotation of e = 0.8 means that it takes 80 cents Australian to purchase one unit of US currency
(that is, $US1).
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So e x Pw takes the foreign price expressed in foreign currency units and converts it into an equivalent
Australian dollar price at the current exchange rate. The numerator and denominator are then in like units – in
this case Australian dollars – and so the movements are unambiguous.
In this case R = (0.8 x $US10)/8 = 1.25 The $US10 translates into $A12.50 and the US produced goods are
more expensive than those in Australia by a ratio of 1.25, that is 25%.
A rise in the real exchange rate can occur if:

The nominal e depreciates; and/or

Pw rises more than P, other things equal.
We consider a rise in the real exchange rate to signal a nation has increased its international trade
competitiveness and this should lead to an increase in local exports and reduce local imports.
A fall in the real exchange rate can occur if:

The nominal e appreciates; and/or

Pw rises less than P, other things equal.
We consider a fall in the real exchange rate to signal a nation’s international trade competitiveness has fallen
and this should lead to a fall in local exports and a rise in local imports.
In Chapters 9 and 10, we considered the factors that might impact on the price level of a nation. In particular, if
prices are set on unit labour costs, then the way to decrease the price level relative to the rest of the world is to
reduce unit labour costs faster than everywhere else or compress profit margins.
With constant profit margins, if the rate of growth in wages is faster than labour productivity growth, then unit
labour costs rise and vice-versa. As we saw in Chapter 10, the real wage is a composite of the nominal wage
determined in the labour market as a result of bargains between workers and employers and the price level,
which is determined by firms in the goods and services market.
The problem is that if a nation attempts to improve its international competitiveness by cutting nominal wages in
order to reduce real wages and, in turn, unit labour costs, it not only undermines aggregate demand but also may
damage its productivity performance.
If, for example, workforce morale falls as a result of cuts to nominal wages, it is likely that industrial sabotage
and absenteeism will rise, undermining labour productivity.
Further, overall business investment is likely to fall in response to the extended period of recession and wage
cuts, which erodes future productivity growth. Thus there is no guarantee that this sort of strategy will lead to a
significant fall in unit labour costs.
There is robust research evidence to support the notion that by paying high wages and offering workers secure
employment, firms reap the benefits of higher productivity and the nation sees improvements in its international
competitiveness as a result.
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15.3
Aggregate Demand and the External Sector – Revisited
In Chapter 8 we developed the income-expenditure framework to explain the way the factors that influence the
production of real GDP (or real national income). The Chapter used the National Accounting concept of GDP at
constant rather than current prices as our measure of economic activity. This built on the development of the
concept of effective demand in Chapter 7 which had focused on expenditure and output in nominal (current
price) terms.
In our income-expenditure framework in Chapter 8 we expressed the flow of total expenditure in any period as
the sum of the following sources of spending:

Consumption by households or persons (C)

Investment spending by firms (I)

Government spending (G)

Export spending by foreigners (X) minus import spending by domestic residents (M), which
we denote as net exports (NX) = (X – M).
From Chapter 8, we know that the equilibrium level of real national income (Y) is determined by aggregate
demand (as long as prices remain unchanged), such that:
(15.2) Y = E = C + I + G + (X – M) = Y
In this Section, we will develop a more detailed account of net exports – (X – M) – to take into account the
influence of the real exchange rate and international competitiveness, which we discussed in Section 15.3.4
(International Competitiveness).
In Chapter 8, our treatment of the determinants of net exports was deliberately very simple. We assumed that
exports (X) were given in any particular period and determined by national income in the rest of the world,
which are beyond the influence of the local economy in question.
We also assumed that a nation imports a fixed proportion of every dollar of national income. We called that
proportion the marginal propensity to import (m) defined it as the extra import spending that occurs as a result
of a dollar increase in national income.
In the previous section (Section 15.3.4 international competitiveness) we learned movements in the real
exchange rate, which is a summary measure of international competitiveness, influences net exports.
We learned that the higher is the value of the real exchange rate, the cheaper are locally-produced goods and
services to foreign buyers, which means they will purchase more of them. In other words, exports rise when the
real exchange rate rises.
Further, the higher is the value of the real exchange rate, the more expensive do foreign-produced goods and
services become to local buyers, which means they will purchase less of them. In other words, imports fall when
the real exchange rate rises.
There are many other factors in the real world that determine the demand for a nation’s exports and the demand
by residents for imports, which we abstract from here in order to focus on the most significant determinants.
We are also abstracting from adjustment responses which are common in international trade. So a rise in the real
exchange rate might only influence future exports once existing export contracts, which tend to be multi-year,
expire. In the following analysis we are simplifying by assuming that the response between movements in the
real exchange rate and changes in the flows of export and import spending are within the current period.
Take exports again. We now assume that the level of exports in any period is determined by the real exchange
rate (R) and world income (Yw) and we write this in the following way:
(15.3) X = λYw + θXR
which might appear at first inspection to be daunting but if you apply the techniques and understandings we
developed in Chapter 4 Methods, Tools and Techniques you will grasp the meaning of this equation fairly
easily.
In Equation (15.3) the Greek letters next to world income (Y w) and the real exchange rate (R) measure how
responsive export spending is to changes in these variables. The coefficient, λ measures how much a nation’s
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export income rises as a result of a rise in world income. If you think about it, λ is, from the perspective of the
rest of the world, its marginal propensity to import.
Similarly, the coefficient θX measures the responsiveness of exports to changes in the real exchange rate.
Remember we are simplifying by assuming this response is immediate and exhausted in the current period.
Later in the Chapter we will introduce lagged responses and consider the J-curve phenomenon, which has been
identified by economists as better described the temporal response of exports to changing real exchange rates.
From our theoretical exegesis, we conjecture that both λ and θ X will be positive. So when world income and the
real exchange rate rises we expect exports to increase.
From the imports side, we assume that the level of imports that a nation purchases depends on both real national
income (Y) and the real exchange rate (R). Thus:
(15.4) M = mY + θMR
The coefficient m is the marginal propensity to import and we know its value lies between 0 and 1. The
coefficient θM measures the responsiveness of imports to changes in the real exchange rate. We conjecture that
this coefficient will be negative, which means that when the real exchange rate rises and the nation becomes
more competitive and foreign goods become more expensive in local currency terms, import spending falls.
If we assume that domestic and foreign price levels are both constant, then movements in the real exchange rate,
R, are mirrored in the nominal exchange rate, e. In other words, we could simply substitute the nominal
exchange rate (e) for the real exchange rate (R) in Equations (15.3) and (15.4) without loss of understanding.
Thus Net Exports (NX) depends on real GDP, real world GDP and the real exchange rate, where the latter
impact is the net result of the impact of the real exchange rate on exports and imports, respectively.
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From blog 16 Nov 12
15.4 Trade in Goods and Services, Product Market Equilibrium and the Trade
Balance
National Income Equilibrium with Trade
In this Section, we continue to assume that Pw/P is constant, which means that domestic and foreign firms
respond to increases in real aggregate demand by increasing real output rather than prices.
Spending on domestic goods determines real output and income. Total spending on domestically produced
goods and services is equal to total spending by domestic residents minus their spending on imports plus foreign
demand for exports.
Referring back to Chapter 8 and Chapter 12 we have the following behavioural equations, which comprise our
theory of aggregate demand:
(15.5) Consumption function
C = C0 + cYd = C0 + c(1 – t)Y
(15.6) Investment function
I = I0 – bi
(15.7) Government spending
G
(15.8) Net exports
NX = λYw – mY + θe
Note that theta is the net impact of changes in the real exchange rate, here expressed as the nominal exchange
rate because we assume that Pw/P is constant.
We can substitute the individual behavioural equations into the equilibrium income Equation (15.2) such that:
(15.9) Y = E = C0 + c(1 – t)Y + I0 – bi + G + λYw – mY + θe
Which, if we refer back to the way we simplified the equations to finally get Equation (8.16), we can write:
(15.10) Y = 1/[1 - c(1 - t) + m] times [C0 + I0 - bi + G + λYw + θe]
This expression for equilibrium national income tells us that real GDP (Y) will be the sum of all the expenditure
terms that do not directly depend on national income (those in the right-hand bracketed expression) times the
multiplier (the first left-hand side term).
We can use this expression to study what happens to national income when one of the terms on the right-hand
side of Equation (15.10) changes.
The Net Exports Function
Equation (15.8) represented net exports (NX) in terms of world income (Yw), domestic national income (Y) and
the exchange rate (e). The latter term was the net impact on aggregate spending of an exchange rate change
taking into account the different impacts on the individual components, exports and imports.
Figure 15.3 shows the Net Exports function in terms of national income. Above the zero point on the vertical
axis the economy would be in trade surplus and below the zero point, a trade deficit.
The Net Exports function is drawn against national income with the other variables in Equation (15.8), Y w and
e, being held constant. If either of these variables changed, the NX function would move up or down, depending
on which of the variables changed and our assumptions about the parameters λ (for a change in world income)
and θ (for a change in the nominal exchange rate).
We have assumed that λ > 0 so that an increase in world income levels boosts our exports and so net exports
rises (other things equal). Further, in our discussion we assumed that the net impact on net exports of a change
in the exchange rate, which is measured by θ is positive. This means that an exchange rate depreciation
improves the trade balance.
In other words we conclude that:

If world income rises (falls) the Net Exports function will move out (in) with an unchanged
slope.
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
If the exchange rate depreciates (appreciates) the Net Exports function will move out (in) with
an unchanged slope.
If we assume both the shift variables (Yw and e) are constant, then as national income rises the trade balance
will be negatively sloped – that is, move from a surplus to a deficit.
This is because as national income rises, imports rise via the marginal propensity to import (m). At point Y 0, the
net exports are balanced (exports equals imports).
To summarise, to the left of NX = 0, there is a trade surplus because, for a given level of exports, the lower level
of income leads to a smaller expenditure on imports. To the right of NX = 0, there is a trade deficit, because at
the higher level of income, imports are higher, relative to the fixed level of exports.
The slope of the Net Exports function is determined by the marginal propensity to import. The larger is the
marginal propensity to import the steeper the slope. This is because the larger is the marginal propensity to
import the greater the leakage from the expenditure stream per extra dollar of national income generated and the
more quickly the trade balance moves into deficit at each income level.
Figure 15.2
Net Exports as a Function of Real National Income
Trade Surplus
0
Y0
National
Income
NX(Yw, e)
Trade Deficit
We can use this understanding and that provided by the equilibrium national income expression (Equation
15.10) to study what happens to national income when world income and/or the exchange rate changes.
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The Impact on National Income and Net Exports of a Change in World Income
We have seen (from Equation 15.10) that the equilibrium level of national income (and real GDP) is dependent
on the level of domestic autonomous expenditure (C0 + I0 + G); the interest-rate sensitive component of
investment (bi); the level of world income (Yw) and the real exchange rate (simplified to e because relative
prices are fixed).
What happens to national income if either the level of world income or the exchange rate changes? In the
analysis that follows we assume that the central bank supplies the monetary base at a constant discount rate, so
that the interest rate charged by the commercial banks can be treated as constant.
Figure 15. 4 reintroduces the Aggregate Demand function from Chapter 8. Recall Figure 8.5 which showed that
a rise in autonomous spending would lead to the Aggregate Demand function shifting up in parallel fashion (the
shift in the intercept being measured by the change in autonomous spending). It is straightforward to generalise
that insight into the current context by noting that the autonomous expenditure components are just the right
hand terms in Equation 15.8 which interact with the spending multiplier.
In Figure 15.3 the trade balance line is denoted as NX = 0. With the other determinants constant (world income
and the exchange rate), we noted that there was one level of national income where the trade account would be
balanced (where imports equal exports). We denoted that level of national income as Y0 in Figure 15.3.
We can translate that knowledge into Figure 15.4 by drawing an NX 0 = 0 line which corresponds to national
income level Y0. All national income levels below Y0 will result in trade surpluses because imports will be
lower than exports, other things equal. All national income levels above Y 0 will generate trade deficits, because
imports will be higher than exports, other things equal.
In our discussion of Figure 15.3, we also noted that the NX line would shift up if world income increased and
down if world income decreased. In the context of Figure 15. 4, this means that the NX = 0 line will shift to the
right if world income rises and to the left if world income falls.
The reason is simple. Start from national income level Y0, which initially coincides with a trade balance NX0 =
0. If world income rises, then at that national income level (Y 0), exports will be higher than before and so the
trade account would be surplus. Trade balance would require a boost to imports, which, in turn, would occur at
higher levels of national income. We denote the new trade balance NX 1 = 0 at Y1.
But we also know that a rise in world income will lead to the rest of the world importing more goods and
services from the domestic economy which means exports rise. As we learned in Chapter 8, if any of the
expenditure components rise, then the Aggregate Demand function shifts upwards.
Figure 15.3 denotes an initial point Y0, which just by coincidence is also a point of external balance. Aggregate
demand is at E0.
The rise in exports pushes the Aggregate Demand function upwards to E 1 and the new national income
equilibrium occurs at Y*. At this point, real GDP is higher, national income is higher and we could show that
employment would be higher and unemployment lower, once the cyclical labour supply adjustments that we
studied in Chapter 10 were exhausted.
You will also note that the economy now has an external surplus, being left of the NX 1 = 0 line (see Advanced
Material for an explanation).
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Figure 15.3
Equilibrium National Income With a Change in World Income
NX1 = 0
Total Expenditure
NX0 = 0
E1
E0
45O
National Income
By way of summary, a rise in world income induces a rise in foreign purchases of the economy’s exports, in the
same way that the local economy’s import demand will be stimulated if its national income rises.
This has two effects:

The Aggregate Demand line (E0) shifts upwards by the initial injection of aggregate demand
from exports (ΔX), giving rise to a new level of equilibrium national income Y *. The increase
in equilibrium national income is given by 1/[1 - c(1 - t) + m] times ΔX, given the constant
interest rate. This is just a specific example of the general result that the aggregate demand
schedule shifts in response to changes in autonomous spending;

The NX = 0 line shifts to the right from NX0 = 0 to NX1 = 0.

Imports rise too because the shift in the Aggregate Demand line (to E 1) means that income
levels are higher. But the shift in the NX = 0 line is greater than the increase in equilibrium
income. Thus NX rise, but by less than the rise in exports. This result holds even if domestic
interest rates rise.
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Advanced Material – An increase in World Income leads to a rise in Net Exports
Prior to the rise in world income, the level of real GDP, Y 0 is consistent with a balance of trade, NX0 = 0.
Assuming no change in the exchange rate, we can write this as:
(15.11)
X0 = M0 + mY0
where the M0 is a constant quantity of imports at the current constant exchange rate.
If we denote ΔX = λΔYw, which is the increase in exports resulting from the rise in world income, then national
income Y1 at which net exports are zero, satisfies:
(15.12)
X0 + ΔX = M0 + mY1
If we subtract Equation (15.11) from (15.12) we get:
(15.13)
ΔX = mY1 – mY0 = mΔY‘
So the change in the level of real GDP, such that net exports are again zero is given by:
(15.14)
ΔY‘ = ΔX/m
On the other hand, the increase in equilibrium real GDP (national income) resulting from an autonomous
increase in exports (driven by the rise in world income) is given by (from Equation 15.10):
(15.15)
ΔY = 1/[1 - c(1 - t) + m] times ΔX
This magnitude is less than ΔX/m because [1 - c(1 - t) + m] > 0.
Thus at the new national equilibrium, Y*, net exports are positive – that is, in surplus.
You should be able to work out what would happen if there was a world recession and world income levels fell.
In this case, the local economy will experience a drop in aggregate demand because exports will be lower than
previously and national income will fall.
The NX = 0 line also shifts to the left and if the economy was, for simplicity, experiencing a trade balance, then
the new equilibrium income level will be associated with a trade deficit (the fall in exports is greater than the
fall in imports).
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