International Finance
Effect on Imports, Exports, and GDP
Recall the formula for gross domestic product, C + I + G + (Ex - Im). The expression (Ex - Im) equals net exports, which may be either positive or negative. If net exports are positive, the nation's GDP increases. If they are negative, GDP decreases. All nations want their GDP to be higher rather than lower, so all nations want their net exports to be positive. (Of course it is not possible for all nations to have positive net exports because one or more nations must import more than they export if the others export more than they import.)
Returning to our example of the United States and Mexico, here is the sequence of events I just described and the impact on trade and GDP:
• U.S. demand for Mexican imports increased.
• This increased U.S. demand for pesos.
• The increased U.S. demand for pesos raised the price of the peso in dollars.
• When Americans purchase more imports from Mexico—holding all else equal—U.S. net exports (and GDP and employment) will decrease.
• However, the change in the exchange rate will automatically correct this situation, because a) as the price, in dollars, of Mexican imports rises, U.S. demand for Mexican imports will fall, and b) as the price, in pesos, of U.S. exports to Mexico falls, Mexican demand for U.S. products will rise.
• When U.S. exports to Mexico rise (because they are cheaper), it will reverse the trend that began when U.S. demand for Mexican products increased. It will also reverse the effect on U.S. net exports, which will increase when exports to Mexico increase.
The price of the peso in dollars—the dollar-peso exchange rate—is determined by U.S. demand for Mexican goods and Mexican demand for U.S. goods. However, when the exchange rate