No Such Thing as a Free Lunch: Principles of Economics (Part 180)

Although economists have studied the sensitivity of import and export volumes to changes in the exchange rate, there is still much uncertainty about just how much the dollar must change to bring about any given reduction in our trade deficit.

Martin Feldstein

Open Economy Macroeconomics: The Balance of Payments and Exchange Rates

(Part B)

by

Charles Lamson

Imports and Exports and the Trade Feedback Effect

The Determinants of Imports The same factors that affect households' consumption behavior and firms' investment behavior are likely to affect the demand for imports because some imported goods are consumption goods and some are investment goods. For example, anything that increases consumption spending is likely to increase the demand for imports. Such factors as the after-tax real wage, after tax non-labor income, and interest rates affect consumption spending; and thus these should also affect spending on imports. A decrease in interest rates, for example, should encourage spending on both domestically-produced goods and foreign-produced goods.

There is one additional consideration in determining spending on imports: the relative prices of domestically-produced and foreign-produced goods. If the prices of foreign goods fall relative to the prices of domestic goods, people will consume more foreign goods relative to domestic goods. When Japanese cars are cheap relative to U.S. cars, consumption of Japanese cars should be high, and vice versa.

The Determinants of Exports The demand for U.S. exports by other countries is identical to their demand for imports from the United States. Germany imports goods, some are U.S. produced. France, Spain, and so on do the same. Total expenditure on imports in Germany is a function of the factors we have just discussed, except that the variables are German variables instead of U.S. variables. This is true for all other countries as well.The demand for U.S. exports depends on economic activity in the rest of the world---rest-of-the-world real wages, wealth, non-labor income, interest rates, and so on as well as on the prices of U.S. goods relative to the price of the rest-of-the-world goods.

If foreign output increases, U.S. exports tend to increase. U.S. exports also tend to increase when U.S. prices fall relative to those in the rest of the world.

The Trade Feedback Effect We can now combine what we know about the demand for imports and the demand for exports to discuss the trade feedback effect. Suppose the United States finds its exports increasing, because the world suddenly decides it prefers U.S. computers to other computers. This will lead to an increase in U.S. output (income), which leads to an increase in U.S. imports. Here is where the trade feedback begins. Because U.S. imports are somebody else's exports, the extra import demand from the United States raises the exports of the rest of the world. When other countries' exports to the United States go up, their output and incomes also rise, which leads to an increase in the demand for imports from the rest of the world. Some of the extra imports demanded by the rest of the world come from the United States, so U.S. exports increase. The increase in U.S. exports stimulates U.S. economic activity even more, which leads to a further increase in the U.S. demand for imports, and so on.

An increase in U.S. imports increases other countries' exports, which stimulates those countries' economies and increases their imports, which increases U.S. exports, which stimulates the U.S. economy and increases its imports, and so on. This is the trade feedback effect. In other words, an increase in U.S. economic activity leads to a worldwide increase in economic activity, which then feeds back to the United States.

Import and Export Prices and the Price Feedback Effect

We have talked about the price of imports, but we have not yet discussed the factors that influence import prices. The consideration of import prices is complicated because more than one currency is involved. When we talk about "the price of imports," do we mean the price in dollars, in yen, in U.K. pounds, in Mexican pesos, etc? Because the exports of one country are the imports of another, the same question holds for the price of exports. When Mexico exports auto parts to the United States, Mexican manufacturers are interested in the price of auto parts in terms of pesos, because pesos are what they use for transactions in Mexico. U.S. consumers are interested in the price of auto parts in dollars, because dollars are what they use for transactions in the United States. The link between the two prices is the dollar/peso exchange rate.

Suppose Mexico is experiencing an inflation and the price of radiators in pesos rises from 1,000 pesos to 1,200 pesos per radiator. If the dollar/peso exchange rate remains unchanged at, say, $0.10 per peso, then Mexico's export price for radiators in terms of dollars will also rise, from $100 to $120 per radiator. Because Mexico's exports to the United States are by definition U.S. imports from Mexico, an increase in the dollar prices of Mexican exports to the United States means an increase in the prices of U.S. imports from Mexico. Therefore, when Mexico's export prices rise with no change in the dollar/peso exchange rate, U.S. import prices rise.

Export prices of other countries affect U.S. import prices.

A country's export prices tend to move fairly closely with the general price level in that country. If Mexico is experiencing a general increase in prices, it is likely this change will be reflected in price increases of all domestically produced goods, both exportable and nonexportable.

The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise.

The Price Feedback Effect We have just seen that when a country experiences an increase in domestic prices, the prices of its exports will increase. It is also true that when the prices of a country's imports increase, the prices of domestic goods may increase in response. There are at least two ways this can occur.

First, an increase in the prices of imported inputs will shift the country's aggregate supply curve to the left. When there is a cost shock, a leftward shift in the aggregate supply curve due to a cost increase causes aggregate output to fall and prices to rise (stagflation).

Second, if import prices rise relative to domestic prices, households will tend to substitute domestically-produced goods and services for imports. This is equivalent to a rightward shift of the aggregate demand curve. If the domestic economy is operating on the upward-sloping part of the aggregate supply curve, the overall domestic price level will rise in response to an increase in aggregate demand. Perfectly competitive firms will see market-determined prices rise, and imperfectly competitive firms will experience an increase in the demand for their products. Studies have shown, for example, that the price of automobiles produced in the United States moves closely with the price of imported cars.

Still, this is not the end of the story. Suppose a country---say, Mexico---experiences an increase in its domestic price level. This will increase the price of its exports to Canada (and to all other countries). The increase in the price of Canadian imports from Mexico will lead to an increase in domestic prices in Canada. Canada also exports to Mexico. The increase in Canadian prices causes an increase in the price of Canadian exports to Mexico, which then further increases the Mexican price level.

This is called the price feedback effect, in the sense that inflation is "exportable." An increase in the price level in one country can drive up prices in other countries, which in turn further increases the price level in the first country. Through export and import prices, a domestic price increase can "feedback" on itself.

It is important to realize that the discussion so far has been based on the assumption of fixed exchange rates. Life is more complicated under flexible exchange rates, to which we turn in the next post. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 694-696*

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