net exports (exports minus imports)

Net Exports (Exports – Imports) – Role in the Circular Flow and Aggregate Demand

1. The Circular Flow of Income – Closed vs Open Economy

The circular‑flow diagram shows how money, goods, services and factor incomes move between the major sectors of an economy. It provides the framework for understanding aggregate demand (AD) and the position of net exports (NX) as either an injection or a leakage.

Sector	Primary Economic Activity	Key Inflows (In)	Key Outflows (Out)
Households	Supply labour, capital, land and entrepreneurship	Factor incomes – wages, rent, interest, profit	Consumption (C) – spend on goods & services (injection to firms) Savings (S) – leak to financial sector Taxes (T) – leak to government
Firms	Produce goods and services	Revenue from sales to households, government and ROW	Factor payments to households Investment in plant & equipment (I) – injection
Government	Collect taxes, provide public goods & services, make transfers	Transfers to households (part of S‑T balance)	Taxes (T) – leakage Government spending on goods, services and public investment (G) – injection
Rest of World (ROW)	Trade in goods, services and capital with the domestic economy	Exports (X) – foreign spend on domestic output (injection)	Imports (M) – domestic spend abroad (leakage) Net foreign investment (capital flows) – affect the financial account

Closed economy: ROW is omitted → only I, G (injections) and S, T (leakages).
Open economy: X and M are added; the net effect (X – M) determines whether the foreign sector contributes to or withdraws from domestic activity.

2. Injections vs. Leakages (AO1 – terminology)

• Injections: Investment (I), Government spending (G), Exports (X)
• Leakages: Savings (S), Taxes (T), Imports (M)

When net exports (NX) = X – M is positive, the ROW is a net injection; when negative, it is a net leakage.

3. Definition and Calculation of Net Exports (AO1, AO2)

Net exports are the balance between a country’s exports and imports of goods and services. They form the fourth component of aggregate demand:

$$\text{AD}=C+I+G+(X-M)$$

Thus,

$$\boxed{NX = X - M}$$

Worked Numerical Example

Item	Value (£ bn)
Exports of goods & services (X)	120
Imports of goods & services (M)	95

Calculation:

$$NX = 120\text{ bn} - 95\text{ bn} = 25\text{ bn}$$

The economy records a net‑export injection of £25 bn, which adds directly to aggregate demand.

Evaluation Checklist (AO3)

• Explain why a positive NX is called a trade surplus and a negative NX a trade deficit.
• Discuss the short‑run impact on output and employment versus the long‑run impact on the current‑account balance.

4. Determinants of Net Exports (AO1, AO3)

• Exchange‑rate movements – Depreciation makes domestic goods cheaper abroad (↑X) and foreign goods more expensive at home (↓M); appreciation does the opposite.
• Foreign income levels – Higher income abroad raises demand for domestically produced exports.
• Domestic price competitiveness – Lower production costs or higher productivity increase export volumes.
• Trade policies – Tariffs, quotas, subsidies and non‑tariff barriers directly affect X and M.
• Terms of trade – Changes in world prices of export goods relative to import goods alter the value of X and M.
• Structural factors – Infrastructure, logistics, and the quality of institutions influence export performance.

Policy Evaluation (AO3)

When assessing any determinant, consider:

• Effectiveness – how strongly does the factor move NX?
• Time‑lag – immediate (e.g., exchange‑rate change) versus long‑run (e.g., productivity improvements).
• Distributional impact – which groups benefit or lose?
• Potential side‑effects – e.g., inflation from a depreciated currency.

5. Impact of Changes in Net Exports on Aggregate Demand and the Economy (AO2, AO3)

• Increase in X or decrease in M → AD shifts rightward → higher real GDP, lower unemployment, upward pressure on the price level (short‑run).
• Decrease in X or increase in M → AD shifts leftward → lower output, higher unemployment, downward pressure on prices.
• Through the multiplier effect, an initial change in NX generates a larger total change in income:
  $$\Delta Y = \frac{1}{1 - MPC(1 - t) + MPI} \times \Delta NX$$ where MPC = marginal propensity to consume, t = tax rate, MPI = marginal propensity to import.
• In the long run, persistent deficits may lead to a build‑up of foreign debt and possible currency appreciation; large surpluses can cause appreciation pressure, reducing competitiveness.

Diagram Guidance (AO2)

Include an AD/AS diagram showing:

• Initial equilibrium (E₀) with AD₀.
• Rightward shift to AD₁ after a rise in NX, labeling the new equilibrium (E₁) and the change in output (ΔY) and price level (ΔP).
• Optional: Show the multiplier effect with a series of concentric arrows.

6. Policy Measures that Influence Net Exports (AO1, AO2, AO3)

Policy	Mechanism	Typical Effect on NX	Evaluation Points
Expansionary fiscal policy (↑G or ↓T)	Raises domestic demand → higher interest rates → currency appreciation	Usually reduces NX (trade‑deficit pressure)	Short‑run boost to output; may worsen the current‑account balance; time‑lag depends on tax‑cut vs. spending.
Contractionary fiscal policy (↓G or ↑T)	Reduces domestic demand → lower interest rates → currency depreciation	Usually raises NX (trade‑surplus pressure)	May increase unemployment; beneficial for the current account; political feasibility.
Expansionary monetary policy (↓interest rates)	Capital outflows → currency depreciation → exports become cheaper	↑NX	Quick impact on exchange rate; risk of inflation; effectiveness depends on capital mobility.
Contractionary monetary policy (↑interest rates)	Capital inflows → currency appreciation → imports become cheaper	↓NX	Controls inflation but may worsen the trade balance.
Direct exchange‑rate intervention	Official buying/selling of foreign currency to re‑value or de‑value the domestic unit	Can be used to deliberately raise or lower NX	Requires large reserves; may trigger retaliation; temporary if market forces dominate.
Supply‑side measures (e.g., productivity programmes, trade‑facilitation, removal of tariffs)	Improves competitiveness → higher X, lower M	↑NX (long‑run)	Long implementation lag; high initial cost; generally sustainable.

7. Net Exports in the Balance of Payments (AO1, AO2)

• Current account records the trade balance (X – M) together with services, primary income (e.g., dividends, interest) and secondary income (transfers). A current‑account surplus implies a net export surplus plus any surplus in the other current‑account items.
• Capital and financial account records net capital flows – foreign direct investment, portfolio investment and other financial transactions.
• Balance‑of‑payments identity: $$\text{Current‑account balance} + \text{Capital‑account balance} + \text{Financial‑account balance} + \text{Statistical discrepancy} = 0$$ Hence, a current‑account deficit must be financed by a surplus in the capital/financial account (or vice‑versa).

Illustrative Example

Suppose a country records:

• Trade balance (X – M) = –£30 bn
• Net services = +£5 bn
• Net primary income = –£2 bn
• Net secondary income = –£3 bn

Current‑account balance = –£30 bn + £5 bn – £2 bn – £3 bn = –£30 bn.

To finance this deficit, the capital‑and‑financial account must show a net inflow of £30 bn (e.g., FDI, portfolio investment).

8. Sample Exam‑Style Questions (AO1–AO3)

1. Define net exports and explain why they are treated as an injection in the circular‑flow model. (AO1)
2. A country’s exports are £80 bn and imports £95 bn. Calculate net exports and state whether the economy has a trade surplus or deficit. (AO2)
3. Explain how a 10 % depreciation of the domestic currency is likely to affect net exports in the short run. (AO2)
4. Using the AD/AS framework, analyse the likely impact on output, employment and the price level of a sustained increase in net exports. (AO3)
5. Evaluate the effectiveness of an expansionary monetary policy in improving a country’s trade balance. Consider both short‑run and long‑run effects. (AO3)

9. Summary Checklist (AO1–AO3)

• AO1 – Knowledge: Know the definition \(NX = X - M\), the four components of AD, and the distinction between injections and leakages.
• AO2 – Application: Be able to calculate NX, draw and shift the AD curve, and use the multiplier formula that includes the marginal propensity to import.
• AO3 – Evaluation: Assess the likely effectiveness, time‑lag, distributional impact and possible side‑effects of policies that influence net exports.