The Net Exports Effect relates to the influence that foreign trade has upon the level of aggregate demand in the domestic economy, and is therefore a key component of the Keynesian consumption function. An increase in exports relative to imports (X-M) implies a net boost to domestic production, and thus a welcome reduction in unemployment during times of recession. To see this, recall that:
AD = C + I + G + (X-M)
If this is unfamiliar, check out my article about: Aggregate Demand
Unfortunately, due to the close interconnectedness of the global economic system, a recession in one country often occurs at the same time as recessions in other countries (especially close trading partners), with the implication that any improvement in net exports for one country often comes with a deterioration in exports for other countries at just the wrong time in the economic cycle.
In years past, the temptation to cause the domestic currency to weaken, either by an outright devaluation (applicable to fixed exchange rate systems) or a depreciation (applicable to floating exchange rate systems) in order to make exports more competitive, would often lead to a sort international trade war with competing countries each trying to undercut one another so as to boost their own economy at the expense of the other.
These types of policies came to be called beggar-thy-neighbor policies, and after repeated costly examples of this sort of nonsense, the developed world moved more in the direction of cooperation in international trade, with various types of trade agreements.
For completeness, I should point out that it was more usually the case that these beggar-thy-neighbor policies would be used to slow down an economy during times of inflation rather than boost them during times of recession. In so doing a country would look to improve its terms of trade by revaluing (or appreciating) its currency so that it could increase living standards by affording extra imports.
As consumers would switch some of their spending towards the now cheaper imported goods, the demand for domestically produced alternatives would fall and thereby ease inflationary pressures. Conversely, the increase in aggregate demand for foreign goods would add to the inflationary pressures in foreign economies, and thereby cause another type of beggar-thy-neighbor trade war.
The long period of low stable inflation from the early 1990s to the early 2020s, as well as the increased global economic cooperation during that period, has greatly reduced the use of beggar-thy-neighbor policies. However, in the 2020s with inflation once again causing economic carnage, it remains to be seen whether or not international trade wars (and perhaps hot wars too) will be avoided as countries compete for access to affordable resources.
The net exports formula is simply value of exports once imports have been deducted:
Net Exports = Total value of exports - Total value of imports
The sum can, of course, be a negative in which case a country is said to have a deficit on its 'balance of trade', this is synonymous with a current account deficit, or simply a trade deficit. Any current account deficit will need to be offset by a surplus elsewhere in the overall national accounts, and this topic is discussed more fully in my article about the: Balance of Payments
Net exports are negative when consumers spend more on foreign goods & services than foreigners spend on domestically produced goods & services. There is no immediate cause for concern when this happens, but if a persistent trade deficit arises such as we have had in the US, the UK, and many other western countries for many decades, then it does become a problem. It can only be sustained by a persistent inflow of capital from foreign shores, and whilst this can be a good thing if that capital is used for investment in new or existing businesses, it is often the case that the inflow is used to buy government bonds i.e. to lend money to the government.
This has facilitated the truly enormous growth of our national debt, and at some point it will become a national catastrophe because our creditors will eventually want their money back. Our inability to pay them will come either with an outright default, or with spiraling inflation and a currency crisis. Either option will cause an economic collapse of staggering proportions. In a nutshell, the west has been living beyond its means for far too long.
The methods for calculating net exports is the same as for national income i.e. the income, output, and expenditure approaches as discussed in my article about: National Income Accounting
Whilst government manipulation of interest rates, and other economic variables, does enable a possible role for Keynesian style demand management, it does not follow that the net exports effect is neutral if left to the free-market... at least not in the short-run.
Any deviation of the economy from its long-run growth path will somewhat distort the pattern of consumption expenditure. For example, if a boom period develops whereby people increase their consumption of goods & services beyond that which can be permanently sustained, then they will tend to increase their consumption of imported goods as well as domestically produced goods.
This will happen independently of the amount of exported goods that foreign consumers decide to purchase from us, with the end result that a trade deficit will develop. The extent to which this happens i.e., the propensity of domestic consumers to increase their consumption of imported goods as their expenditure/income increases, is known as the marginal propensity to import (MPM).
A higher MPM will likely exist for countries that import a large share of their luxury goods, because it is luxury goods that people want to increase their consumption of whenever economic circumstances allow it. If a country only imported basic items like rice, grain, pots and pans etc, then the MPM would be low because people would be more likely to increase their spending on things like smartphones, notebooks, concerts, expensive restaurants and so on.
A high MPM has a stabilizing effect on the economy because it reduces the net exports effect. Extra spending on imports represents a leakage from the national circular flow of income, and that helps to stop the consumption function from rising as fast as it otherwise would.
As mentioned at the top of the page, net exports is one of the components of aggregate demand that, along with aggregate supply, determines national income i.e. GDP. An increase in net exports can be illustrated as an upward shift of the Keynesian consumption function. This will lead to a higher level of GDP, and the extent to which GDP increases is determined by the size of the Keynesian multiplier effect (click the links for details).
This, of course, assumes that there is spare capacity in the economy to allow that growth, and that opens a whole new debate which cuts to the core of modern economics. Again, click the links for details on that.
In the developing world, economists have tried many different approaches to spurring poor countries into growth, and by far the most successful of these approaches has been the export led approach. The main alternative i.e., the import substitution model, has always failed.
All of the 'Asian tigers' succeeded in achieving rapid economic growth by following an export led strategy. The main advantage here is that it opens up the domestic economy and allows an inflow of international capital to invest in manufacturing plants that can then utilize the cheap labor in these poor countries. The opening up of the economy exposes it to international competition, and the efficiency which that necessitates spurs rapid growth in GDP.
All of the Asian tigers developed huge GDP boosts via the net exports effect, with huge trade surpluses that have allowed an accumulation of foreign assets to be built up. According to the UN, over a billion people have been lifted out of poverty since 1990, and this largely due to the export-led growth in China and elsewhere in the developing world.
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