Economics: Changes in Net Exports

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If you look closely at the circular flow diagram, you can see two ways of describing equilibrium in Keynes' view of the macro economy. One view says that spending has to equal income; that is, what flows around the outside on top has to come back on the bottom. Another view says that anything that leaks out of the circular flow has to be injected back in at some point. That is, all of the money that households don't spend on goods and services-what they save by putting in the bank or a mutual fund; what they pay in taxes, sending to the government-has to flow back in. Because when their demand is reduced, demand has to increase somewhere else to compensate. Either business buying goods and services with the money that households have lent to banks, or the government buying goods and services with the tax funds that households have paid. Let's now add one more set of players to the circular flow before we take a final look at the equivalence of the income approach and the savings approach to describing macroeconomic equilibrium.
The last set of the players that we are going to add is the rest of the world. That is, people outside of the US economy. In this case, the rest of the world represents the movement from a closed economy to an open economy. That is, once we're including the behavioral foreigners now, we're talking about the place of this particular economy in the rest of the world. And here's how foreigners enter the picture.
Foreigners buy stuff from our economy, we call that our exports--the goods and services we send abroad. We also buy stuff from foreign countries, we call that our imports, the goods that we purchase that are shipped to us from abroad. Now, the difference between our exports--that is, what we sell to foreigners--and our imports (what we buy from foreigners) is called our net exports, and our net exports is a flow of goods and services abroad. We call this an injection into the circular flow because it is demand that is injected back into the system when foreigners want to buy our stuff.
Now, net exports--the relationship between the amount of goods we are able to sell to foreigners and what we buy from them--depends on several factors. First of all, it depends on preferences. When people in the domestic economy decide they like foreign goods, they'll import more of them. When foreigners decide they want more of our products, then we'll be able to export more. Next, it depends on income. When income increases in our domestic economy, we're going to spend part of that on exports and net exports can shrink when our economy is booming because our import bill will rise. A third factor is trade barriers: tariffs, quotas and other government negotiated restrictions on trade. When those occur, it may be difficult for us to export. Or, when our own government imposes tariffs, it's harder for us to import goods. A fourth factor is the exchange rate. Whenever the value of the US dollar changes relative to the value of the German mark, people in both economies will adjust their behavior. When the dollar becomes relatively strong, or expensive, then Germans are less inclined to buy goods from the United States because they are more expensive, measured in terms of German marks, their home country currency. On the other hand, Americans are very excited because German imports now look like a bargain. So these four factors influence the volume of net exports.
Now that we have got the circular flow diagram complete then, let's look at an algebraic representation of the equivalence between the two approaches to equilibrium. That is, let's start with the spending equals income condition, and use an identity about income to derive the savings explanation for equilibrium. Watch, here's how we'll do it.
Let's start with this equation: Y = C + S + T. You've seen this before; this is the description of what households can do with their income. All of the income that you get, winds up in one of three places. You spend it on goods and services, you put it in the bank or a mutual fund or buy stocks or bonds with it-that is, you save-and finally you pay taxes to the government. These two components are a leakage. These are a leakage out of the circular flow. This is household demand, this is the thing that creates jobs and business activity. So, we start then with an algebraic representation of the equilibrium condition. Income equals aggregate expenditure. That is, the income in the economy is equal to what consumers, businesses, the government and foreigners are spending on the output of factories.
Now, since this income and this income are the same thing, we can set this equation equal to this one as I've done here below. And if I cancel the C from both sides, I can rearrange this expression by moving government expenditure over to the left-hand side and net exports over to the left hand side. Now look what I've got, I've got a statement about macroeconomic equilibrium in terms of leakages and injections, or in terms of savings and investment. It's the same thing to say that income equals expenditure, and to say that savings equals investment. Those are mathematically equivalent statements that represent macroeconomic equilibrium. Look at the intuition. Businesses borrow money to buy factories, plant equipment, to spend on research and development, and things like that. All this business spending comes out of money that people have lent to business so that they can undertake business activity.
But where does that savings come from? It comes from three sources, it comes from households, which we represent by S, and this is the money that households are not spending on goods and services, or paying in taxes. It comes from the government. See, if the government takes more in in revenue than it spends on goods and services, then the government runs a budget surplus and the government budget surplus is a form of savings. This is money the government is saving and it's available to be lent to businesses. Finally, there is what we call our trade deficit, and our trade deficit is the amount by which our imports exceed our exports. Notice here I have our net exports with a negative sign. This is now net imports, the amount by which we are buying more from foreigners than we are selling to them. Now how are we able to buy more from foreigners? It must be that foreigners are lending us money to do that. So this is a flow of savings into our economy, when we run a trade deficit than foreigners are lending us their savings.
The combination of household savings, government savings and the savings that foreigners have lent us totals to the amount of money that businesses are borrowing to build plant, and equipment and expand their activities. That means if one factor in this equation changes, something else has to adjust to restore equilibrium. For instance, if the government spending were to increase, than the government budget surplus would shrink, or it may be even the government would run a deficit. In this case, the government is absorbing more of the savings that are in the economy, leaving less for business. The only way for us to keep business spending constant if government spending were to increase, would be either for the government to increase taxes or for savings to increase in our economy or for us to run a bigger trade deficit. Something has to give when one variable in this equation changes.
Let's now look at this graphically, and here's our final look at this Keynesian cross diagram, the aggregate expenditure picture. Let's suppose now that net exports increase. That is, suppose that foreigners are going to buy more stuff from our economy, perhaps because of a depreciation in the US dollar, or a change in trade policy, or a general shift in preferences of foreigners towards American made goods. In that case, the red expenditure line is going to shift upwards. As it shifts upwards now, we have more spending at every level of income. So net exports increasing means more expenditure in the economy. And I can draw that new aggregate expenditure curve in, in red, so we can calculate our new equilibrium: consuming, business spending, government spending, plus our new larger quantity of net exports. An increase in net exports increases equilibrium income in the economy, so equilibrium income increases we go to this new place, where the red line crosses the black dotted line, and we get our new level of equilibrium output, Y-prime. The change in output is equal to 1/1 - B times the change in net exports. That's a straightforward application of our multiplier.
But look what happens down below. Down below when net exports increase, that is a reduction in savings that's available in our economy. That is, now that foreigners are buying more of our stuff, they are less likely to be lending us money. So the amount of savings that's available in the economy shrinks. Net exports shifts the expenditure upwards at the same time as it shifts the savings curve downwards, and when that happens the equilibrium point where savings is equal to investment spending is going to change. That is, it gives us the same level of output as we had upstairs.
So see, there's two ways of representing the change in net exports: as an increase in expenditure, or as shrinkage in savings. Either way, you get an increase in the equilibrium level of output equal to the change in autonomous spending--the change in net exports times the multiplier. There's two ways of representing any change in the economy: you can either look at it on the outside of the circular flow wheel in terms of income equals expenditure-those have to be equivalent in equilibrium. Or you can look at the flows into the wheel, that is the leakages out of the circular flow and the injections back in: savings equals investment. Anything that shrinks the total amount of savings is going to change the equilibrium level of income.
Well there you have it... Keynes' view of the world in which demand drives everything. You've seen it in a picture, you've seen it graphically, and you've seen it with simple algebra. Now you can apply it to explain how changes in the economic environment change output and with it, employment.
Aggregate Expenditures Model
Comparitive Statics: The AE Model
Changes in Net Exports Page [2 of 2]