2.2.5 - Net trade (X-M)

What Net Trade Shows

Net trade compares what a country sells abroad with what it buys from abroad. Exports are goods and services sold to overseas buyers, while imports are goods and services bought from overseas producers.

In macroeconomics, net trade is usually written as:

If exports are greater than imports, the country has a trade surplus. If imports are greater than exports, it has a trade deficit. A deficit does not automatically mean an economy is failing, but it does mean some spending is supporting foreign output rather than domestic output.

For the UK, this matters because the country has often imported more goods than it exports, although service exports help offset part of that gap. That is why economists focus on the balance, not just on exports or imports in isolation.

Income and World Demand

One of the biggest influences on net trade is income at home and abroad. The key idea is asymmetric: changes in domestic income mainly affect imports, while changes in foreign income mainly affect exports.

When UK real incomes rise, households and firms usually spend more. Some of that extra spending falls on imported goods and services such as electronics, cars, raw materials, or foreign holidays. If imports rise by more than exports, net trade (X - M) worsens.

During a recession, the reverse often happens. Lower incomes and weaker confidence reduce spending, so demand for imports falls. This can improve the trade balance even though the wider economy is weaker.

Foreign income matters on the export side. When consumers and firms in Europe, the US, and other overseas markets enjoy rising incomes, they are more willing to buy UK goods and services. When the world economy slows, export demand weakens. During the 2008-09 global downturn, UK exporters faced weaker demand because major overseas markets were slowing at the same time.

Because the EU is such an important market for UK firms, weak growth there tends to matter far more than weak growth in a much smaller trading partner. So world demand is not just about whether the global economy is strong or weak, but also about which economies are growing.

Exchange Rates and Timing

The exchange rate is the price of one currency in terms of another. If sterling falls in value, UK products become cheaper for foreign buyers, while imports become more expensive for UK consumers. That tends to raise exports and reduce imports.

An appreciation usually has the opposite effect: UK exports become dearer abroad and imports become cheaper at home. A useful shortcut is SPICED: strong pound, imports cheap, exports dear.

However, a depreciation does not guarantee that the trade balance will improve. The outcome depends on how responsive buyers are to price changes. If demand for exports and imports is price inelastic, the quantity response may be small. Import volumes then fall only slightly while each import costs more in pounds, so spending on imports can actually rise, and export volumes rise too little to make up the difference. This is the logic behind the Marshall-Lerner condition: a depreciation improves net trade when the price elasticities of demand for exports and imports, added together (ignoring the minus signs), are greater than 1. If they add up to less than 1, the trade balance worsens.