3.2.2
Note

Consequences of a Balance-of-Trade Increase

3.2.2 Macro issues

Idea

A rise in the balance of trade raises net exports (X − M), a component of aggregate demand, and so feeds into national income. This note catalogues the effects on each agent of a higher balance of trade, and contrasts them with the effects of an inflow of foreign direct investment; it reaches no verdict.

Mechanism

When the balance of trade rises, net exports rise, increasing aggregate demand (AD). Through the multiplier process national income rises — actual growth. As the economy expands towards full employment, demand-deficient unemployment falls. Rising incomes lift consumers’ disposable income and purchasing power, so consumption rises; the higher demand for domestic goods leads producers to expand output, raising profits and employment, while improving investor confidence raises investment.

Diagram

General price level (GPL)Real national output (RNO)AD₀AD₁LRAS₀LRAS₀Y₀Y₁P
A rise in the balance of trade raises net exports and shifts aggregate demand right from AD₀ to AD₁ along the horizontal range of LRAS, raising real national output from Y₀ to Y₁ — actual growth — with the general price level unchanged at P.

Considerations

An inflow of foreign direct investment is a useful contrast. FDI raises investment, and so AD, and at the same time raises the quantity and quality of resources, and so productive capacity and LRAS. Because demand and capacity expand together, output rises with no upward pressure on the price level — non-inflationary growth — distinguishing FDI-led growth from the demand-led growth a higher balance of trade produces on its own.

General price level (GPL)Real national output (RNO)AD₀AD₁LRAS₀LRAS₁LRAS₀Y₀Y₁P
Foreign direct investment raises both aggregate demand (AD₀ to AD₁) and long-run aggregate supply (LRAS₀ to LRAS₁) in tandem, so real national output rises from Y₀ to Y₁ with the general price level unchanged at P — non-inflationary growth.

A separate caution attaches to capital inflows that are not FDI: a large inflow of portfolio investment or hot money appreciates the currency, which makes exports dearer and imports cheaper and so tends to worsen the balance of trade — the opposite of the effect traced above.