The Net Exports Effect
The “net exports effect” is the impact on a country’s total spending caused by an inverse relationship between the price level and the net exports of an economy. Using this principle, discuss how the following economic variables change during an economic expansion:
- The balance of payments
- The rate of interest
- The value of the dollar
In your answer, also discuss the case in the context of both a flexible exchange rate and a fixed exchange rate.
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Why Nations Trade
Why do countries trade? Shouldn’t a strong country such as the
Because countries have different natural, human, and capital resources and different ways of combining these resources, they are not equally efficient at producing the goods and services that their residents demand. The decision to produce any good or service has an opportunity cost, which is the amount of another good or service that might otherwise have been produced. Given a choice of producing one good or another, it is more efficient to produce the good with the lower opportunity cost, using the increased production of that good to trade for the good with the higher opportunity cost.
When a country can produce more of a good with the same resources that another country can, it is said to have an absolute advantage in the production of that good. If the second country has an absolute advantage in producing a good that the first country wants, both will be better off if they specialize and trade.
But trade is usually beneficial to both countries even if one has an absolute advantage in the production of both goods that are to be traded. Given any two products, a nation has a comparative advantage in the product with the lower opportunity cost. The terms of trade must be such that both countries lower the opportunity costs of the goods they are getting from the trade.
Why do countries have different opportunity costs? They have different endowments of productive resources -warmer climates and longer growing seasons; more plentiful natural resources such as oil, iron ore, and water; more highly educated and skilled workers; and larger quantities of more sophisticated machinery.
World trade is not static. It has been increasing both in amount and in significance. New supplies of natural resources can be discovered and developed while existing supplies are better managed. Human resources can be improved through better educational programs. Capital resources can be acquired to make the better trained workers even more productive.