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International Trade and Aggregate Demand

International Trade and Aggregate Demand

Author: Kate Eskra
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This lesson covers the international trade and aggregate demand. 

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Tutorial

INTERNATIONAL TRADE AND AGGREGATE DEMAND

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is on international trade and aggregate demand. As always, my key terms are in red and my examples are in green.

In this tutorial we'll talk about how international trade can impact aggregate demand. We'll look at how changes in exchange rates can also impact GDP in a country, as a weaker currency encourages exports and discourages imports. And we'll look at China as an example of a country whose used their currency to help them achieve economic growth.

So we know that international trade just means the flow of goods and services, and capital, too, among countries. And it's been taking place throughout history. This is nothing new. But what is new is that more and more and more every decade, its importance really does increase. And there are political effects of this, social effects, but obviously in this economics tutorial we'll be mainly talking about the economic effects of it. So here what we're looking at is how trade and exchange rates can affect conditions in the countries involved.

So first of all, remember that imports are just goods and services brought into a country and produced by foreign nationals. And exports are goods and services sold and transported outside a country of origin to a foreign country.

So remember our equation for finding aggregate demand. Aggregate demand is combined of consumer purchases, investment purchases, government purchases, and what we're focusing on here is net exports.

So net exports are exports minus imports. What that means is that if exports increase, that means that aggregate demand is going to increase and shift to the right. If exports decrease, then aggregate demand will decrease and shift to the left. Remember, an increase in aggregate demand increases a country's GDP. A decrease in aggregate demand decreases a nation's GDP.

OK, so with that all in mind, the big idea that I want to walk you through is what's happening in one country's economy can absolutely impact other nations' economies. It's not just an isolated event when something happens in one country anymore.

When the United States is in a recession, this can have an impact almost throughout the entire world. When we're in a recession, one of the things that's going on is that United States consumers are buying less, and we're not just buying less from our own people, we're buying less of everything. And so that includes imports. So any country at all that relies on our demand will see a decrease in their aggregate demand. So for one small example, Japan would be exporting fewer cars to us when we're in a recession.

So let's talk about the effect of exchange rates because this is a little bit more technical. The big idea here is that changes in exchange rates can impact a nation's exports and imports, which affects aggregate demand and overall economic conditions. So remember that an exchange rate is simply the cost of one country's currency relative to another's. And how strong or weak our currency is relative to other currencies can impact, first of all, how much we want to purchase foreign goods-- so how much we want to import. And how much foreigners want to purchase our goods, or how much we export.

So if, in this example, the United States dollar depreciates or becomes weaker relative to the euro, that's going to have two effects. First of all, now American products have become cheaper to attain because our currency is weaker relative to the euro. At the same time, it's now more expensive for us to get European products.

So what overall impact will this have? This could have an increase in our exporting, because remember, our goods are now cheaper for others to attain. So our exports, and therefore our aggregate demand could go up. Keep in mind that could increase our GDP. At the same time, Europe's exports and aggregate demand could fall.

So you might start here by asking yourself, hmm, so if a nation really wants to encourage a lot of exports, can they actually try to have a weak currency? I don't know if you were thinking that or not, but maybe you were. Well, China until pretty recently actually provides a really good example of this. So let's walk through it.

So China's currency, I'm just going to call it the RMB. That's the abbreviation for it. But it's also known as these things, which I'm not even going to attempt to correctly pronounce. So I'll call it the RMB.

Instead of allowing their currency's value to be determined by global supply and demand, they decided back in the 1980s when they wanted to begin trading, to peg its value against the US dollar. OK, so this deals with a difference between a floating currency and a pegged currency. This is a mechanism for exchange rate pricing.

A floating rate moves with market forces. So that would be when you move with the supply and demand. A pegged rate, which is what we're talking about with China here, is a maintained value of a currency, where the value is maintained by a central banking of foreign exchange regulating body, and it's typically defined in a range.

OK, so that's what China did. China kept its currency very weak relative to the United States dollar in order to entice Americans to purchase Chinese goods. So when they kept their currency very weak, that meant that we could exchange US dollars for a lot of their currency. That would also discourage exports of US goods to China because it was expensive to exchange RMB for US dollars.

So what's the result then? The result was that United States exports to China have been roughly about one third of Chinese exports to the United States. That's a huge trade surplus for China, and a huge trade deficit for the United States.

What is the demand then? Because when you're buying a whole lot of Chinese goods, shouldn't the demand for their currency increase? Well yeah, it should have. So normally that would appreciate their currency, making it stronger and not having the kind of impact that it was having. But when you have a pegged currency, the Chinese central bank was keeping the RMB undervalued through a lot of expansionary monetary policies.

Remember, when you have expansionary monetary policies, you're supplying more. And any time there's a greater supply of something, it weakens the value of it. And that's what they did to maintain the peg. So this could be good for China and bad for the United States. That's why it's called a controversial policy.

We talked about how it's good for China. It allowed their economic growth to just take off by significantly increasing their aggregate demand because they were exporting so much and not importing as much. When you increase your aggregate demand, you're increasing your GDP and employment rates. It also encouraged a lot of foreign investment in China.

But how is this bad for the United States? Well, United States manufacturers argued that it is absolutely impossible to compete with these artificially cheap Chinese goods because of this weakened currency. But others actually say, you know what, maybe it's actually not been so bad for us.

In some ways, it's provided a lot of cheaper goods for US consumers, so a way for us to get things that would have been more expensive otherwise. You could argue that any manufacturers who do purchase from China receive cheaper input prices. And so some have actually said, you know, has it actually increased the standard of living in our country, since it's been US consumers purchasing almost all of these goods? So just some food for thought, something to think about.

So in this tutorial we looked at how international trade can impact aggregate demand because exports and imports are a component of aggregate demand. Changes in exchange rates can also impact GDP in a country, as that weaker currency can encourage exports but discourage imports. And finally, we talked about the controversial issue of how China being an example of a country who maintained that pegged currency for a while to help them achieve economic growth.

Thanks so much for listening. Have a great day.

Terms to Know
Exchange Rates

The cost of one country’s currency relative to another’s.

Exports

Goods and services sold and transported outside a country of origin to a foreign country.

Float/Peg

A mechanism for exchange rate pricing; a floating rate moves with market forces; a pegged rate is a maintained value of a currency where the value is maintained by a central banking of foreign exchange regulating body and is typically defined in a range.

Imports

Goods and services brought in to a country and produced by foreign nationals.