Edexcel A-Level Economics · Revision notes

2.2.5 Net trade (X-M)

Net trade is the value of a country's exports minus the value of its imports, written (X − M). Exports add to demand for UK output because foreign consumers are buying it; imports take demand away because UK residents are spending on output produced elsewhere. For the UK, net trade is usually small and negative, at around −1% of GDP, but exports and imports are each very large, so changes in either can move aggregate demand significantly.

Exports, imports and the trade balance

• Exports (X) are goods and services produced in the UK and sold abroad, such as cars sold to Germany or financial services sold to clients in New York.
• Imports (M) are goods and services produced abroad and bought by UK residents, such as clothes made in Bangladesh or holidays in Spain.
• Net trade is X − M. If exports exceed imports, there is a trade surplus and net trade adds to AD. If imports exceed exports, there is a trade deficit and net trade subtracts from AD.

The factors below change the trade balance by affecting exports, imports, or both.

Real income

Real income in the UK affects imports. When UK incomes rise, households spend more, and some of that extra spending goes on imported goods and services. So rising UK income tends to increase imports and worsen the trade balance. In a recession, falling incomes reduce imports and the trade balance tends to improve.

Real income abroad affects exports. When incomes rise in the UK's main trading partners, they buy more UK goods and services, so exports rise.

The share of any extra income spent on imports is the marginal propensity to import. The UK's is relatively high, because it imports many of the goods its consumers buy.

Exchange rates

The exchange rate is the price of one currency in terms of another. It changes the price of exports and imports without any change in their price at home.

• A fall in the value of the pound (a depreciation) makes UK exports cheaper for foreign buyers and imports dearer for UK buyers. Exports tend to rise and imports to fall, so the trade balance tends to improve.
• A rise in the value of the pound (an appreciation) makes exports dearer abroad and imports cheaper at home, so the trade balance tends to worsen.

A simple way to remember the effect of a rise is SPICED: a Strong Pound makes Imports Cheap and Exports Dear.

Evaluation: How much the trade balance actually changes depends on how sensitive demand for exports and imports is to price. If demand is price inelastic, a depreciation may improve the balance only slowly, or not at all.

The state of the world economy

Exports depend on the health of the economies that buy them. When the global economy grows strongly, demand for UK exports rises. When major trading partners fall into recession, as many did after the 2008 financial crisis, UK exports fall, whatever happens in the UK itself.

This makes the UK economy partly dependent on conditions it cannot control, especially in its largest export markets, the United States and the European Union.

The degree of protectionism

Protectionism is the use of barriers to restrict trade, such as tariffs (taxes on imports), quotas (limits on the quantity of imports) and regulations that make importing harder.

• If other countries raise barriers against UK goods, UK exports fall.
• If the UK raises barriers against foreign goods, imports fall, but other countries may retaliate against UK exports.

Changes in trading arrangements also matter. Leaving the EU's single market and customs union at the end of 2020 added customs checks and paperwork to trade with the UK's nearest and largest trading partner.

Non-price factors

Price is not the only reason customers choose one country's products over another's. Non-price factors include:

• Quality and reliability of the product;
• Design and innovation;
• Brand reputation, such as the image of British luxury cars or Scotch whisky;
• After-sales service and the speed and reliability of delivery.

Key idea: A country whose firms are strong on non-price factors can sell abroad even when its prices are relatively high. German car makers such as BMW and Mercedes-Benz, for example, sell well around the world despite high prices, because buyers value their reputation for quality and engineering.

Germany's manufacturing exports are often cited as an example. Non-price competitiveness depends on investment, skills and innovation, which take years to build.

Key terms

Common mistakes

• Getting the exchange rate effect backwards. A fall in the pound makes exports cheaper abroad and imports dearer at home.
• Linking UK income to exports. UK income mainly affects imports; foreign income affects exports.
• Assuming a depreciation always improves the trade balance. It depends on the price elasticity of demand for exports and imports.
• Ignoring non-price factors. Competitiveness depends on quality and reputation as well as price.
• Treating a trade deficit as a sign of a weak economy. A strong economy with rising incomes often imports more.

How this has been examined

This topic has not appeared as a standalone question in the Edexcel papers indexed on this site.

The same influences are examined through the balance of payments, exchange rates and international competitiveness, all of which build on this topic.

Where this goes next

Net trade is one of the four components in 2.2.1 The characteristics of AD. The current account it feeds into is covered in 2.1.4 Balance of payments. Exchange rates are examined in depth in 4.1.8 Exchange rates, protectionism in 4.1.6 Restrictions on free trade, and price and non-price competitiveness in 4.1.9 International competitiveness.