Trade affects both spending and productive conditions.
Government purchases depend on budget priorities and spending decisions. Exports depend on foreign incomes, relative prices, exchange rates and non-price competitiveness such as quality and reliability. Imports depend on domestic incomes and demand, relative prices and the need for foreign inputs. A currency depreciation can make exports cheaper to foreign buyers and imports dearer to residents, but the net-export response depends on demand responsiveness, contracts and time. Trade also affects productive capacity and costs through inputs, equipment, knowledge and competition; its role is wider than subtracting M in the AD identity.
- Government purchases
- Budget priorities affect G: purchases of goods and services rather than cash transfers alone.
- Exports
- Higher foreign incomes can let overseas customers buy more domestic exports, raising X. Relative prices, the exchange rate, quality and reliability affect which goods they choose.
- Imports
- Higher domestic income or demand for foreign inputs can increase M. Imports also provide equipment and materials that local production may need, so trade affects supply as well as demand.
Apply the idea
Exchange-rate caution
An exchange rate is the price of one currency in another. Depreciation means the domestic currency buys less foreign currency. With other prices unchanged, exports become cheaper for foreign buyers and imports dearer for residents. The net-export response still depends on how purchases react, contracts and time; imported-input costs can rise too.
Trade and AS
Imported equipment and inputs can support productivity and capacity; disrupted supplies can raise costs or restrict output.
Identify domestic content
An imported machine is included in expenditure on investment but offset in M. Domestic delivery or installation value can still contribute to domestic output.
Worked example: Foreign orders now, productive equipment later
Foreign demand for local logistics services rises. Firms also buy more imported equipment that can improve productivity once installed. Installation takes time, and the domestic value of installation services is recorded separately.
- The additional foreign purchases of local services increase X and support higher AD at each general price level.
- The foreign-produced part of equipment spending is included in investment spending but offset through M when measuring immediate demand for domestic output. Domestic installation services can still add local demand.
- Once operating, the equipment may let firms make more output with the same resources or at a lower cost per unit. That supports an AS shift down/right: more output supplied at a given price level. The effect is not necessarily immediate.
- The overall short-run AD movement depends on the net changes in all components; the longer-run supply effect requires effective installation and use.
Watch out for this
Imports always reduce national prosperity because M is subtracted in AD.
The subtraction is an accounting correction. Imports can provide consumption variety, inputs and capital that support productivity and output.
Check your understanding
Foreign incomes rise and overseas buyers order more domestically produced services. Other things equal, what is the direct AD effect?
- AD shifts left because exports are a withdrawal.
- There is only a movement along unchanged AD.
- AD shifts right through higher exports.