Aggregate Supply

The conventional "bipolar" view of supply and demand macroeconomics becomes more complex, particularly on the supply side, when a nation enters into an international trade relationship. Nations may, in an effort to bolster their domestic product or enhance their international standing, employ a number of policies to satisfy the needs of their internal infrastructure — under certain conditions, these efforts may prove fruitful (although controversial to foreign parties).

Keywords Aggregate Supply; Currency Devaluation; Foreign Demand; Inflation; International Trade; Most Favored Nation; Tariffs

Economics > Aggregate Supply

Overview

The French economist, statesman and author Frederic Bastiat (1801-1850) once said, "By virtue of exchange, one man's prosperity is beneficial to all others" (Liberty-Tree.ca, 2007). Indeed, international trade is arguably the most integral component of the now-global economy. However, as difficult as it is to fathom, the present era of global networks and international trade among virtually every nation around the world is relatively young in human historical terms. As recently as the pre-World War II era, the world was a much more disjointed place with factions trading selectively with their allies, and others not trading at all. Even more mind-boggling is the fact that these arrangements were made by choice. Trade relationships, if not long-standing (such as those between the US and its allies in Europe), were often established not by diplomatic missions, but through wars and post-war negotiations.

Japan, for example, sought to garner many of its most prized resources through military operations in the 1930s. Its strongest trade ally (until its militaristic leanings became apparent) was the US, through an exclusive, bilateral arrangement made at the end of the Tokugawa era in the late 1860s. After the war and the dismantling of Japan's military machine, the US largely rebuilt nearly every facet of that country. The US, whose economy leapt out of the Depression, gave new fiscal life to the Japanese people, including a military-based consumer demand (thousands of US soldiers and personnel became part of the Japanese economy after the war through the present). The Korean War exacerbated that dependence, as not just American personnel but troops from 15 other nations descended on Japan as a staging area. Japan did not need to proactively establish trade relationships on the international stage — the world came to Japan.

When the Japanese economic engine restarted in the post-war era, the country looked disproportionately inward at using its aggregate supply to satisfy domestic demand, despite the fact that it has long produced high-quality, exportable goods. Japanese policy has been to focus those products on an intrastate basis and maintain strict import restrictions. Their trade imbalances have also reached significant proportions, as that nation, in 2000, maintained foreign reserves of nearly $300 billion (National Economies Encyclopedia, 2007). Since then, international clamoring over opening Japanese markets to foreign imports has achieved some success, but a clear imbalance remains.

Japan's example above is indicative of the intricacies and delicate nature of international trade and of a sort of "tug-of-war" in economics over aggregate supply. As this paper will demonstrate, international trade tends to pull supply in different and often conflicting directions. To maintain supply for both trading partners and domestic consumers, nations may employ a number of policies to satisfy the needs of their internal infrastructure — under certain conditions, these efforts may prove fruitful (although controversial to foreign parties).

Aggregate Supply & Trade

Plutarch once recalled a fable of Menenius Agrippa about an attempted mutiny by other human organs against the stomach, which they accused of being "the only idle, uncontributing part in the whole body." Only after they ousted the stomach did the organs realize their mistake, as they were left with the arduous task of generating the large supply their appetites demanded (Bartlett, 2005).

As Plutarch's story of Coriolanus suggests, supply plays an absolutely essential role in any macroeconomy. Aggregate supply, the total sum of goods and services produced by an economic system, is a vital counterbalance to consumer demand. There are a variety of elements that influence supply as it relates to demand. Among these factors are the available labor force, employee salaries, corporate and commercial taxes (and, on the positive side, government subsidies), new technologies and consumer investment (Tutor2U.net, 2007).

Without a labor force and the ability to pay them, industries cannot meet the needs of the customer. Likewise, if the government applies a disproportionate tax levy on doing business rather than providing tax incentives or exemptions, business may falter. New technologies also play a role, often making the difference between cost-effectiveness and inefficiency. Furthermore, investment, from either a domestic source or from foreign entrepreneurs, help provide vital resources for manufacturers and service providers to meet the demands of consumers. Still another contributing factor is inflation: If consumer incomes are high and product stock cannot meet customer desire to buy, the imbalance can adversely impact manufacturers and service providers by instigating an increase in prices. Put simply, the supply side of a macroeconomy, as it relates to domestic demand, is already sensitive to a variety of potentially beneficial or harmful influences.

Exacerbating the significant draws on supply resources is international trade. When adding interstate relationships to the mix, the supply side is not only subject to the demands of domestic consumers, but to the needs of consumers in partner systems. In trade relations, therefore, supply is fluid and dynamic, subject not only to internal forces but to external elements as well. If one views macroeconomics as a teeter-totter (with supply and demand in opposing seats), trade acts as a force pulling the supply side in a different direction while it contends with its polar counterpart.

Because of the many directions from which supply is pulled in international trade contexts, it is therefore sensitive and reactive. Nowhere in international economics is this statement truer than it is with oil prices. After all, the price of oil affects transportation, heating, manufacturing and countless other industries. It is no wonder that any spike in oil prices causes a ripple effect in an economy. In a study of the 1973-74 energy crisis (and subsequent inflation), one economist echoes the view that "an increase in oil's relative price will cause an adverse shift in the aggregate supply curve that produces a higher price level and lower output" (Darby, 1982). Judging from the impact of oil price spikes on a wide range of industries (as well as the cost of living in any industrialized country) in the early 21st century, this method of thought seems validated.

Are there other factors that can impact aggregate supply in an international trade relationship? Although the oil example provided above, demonstrative of the effectiveness of pricing as a trade mechanism, is a well-established "x-factor" in industry and therefore supply-side economics; it is certainly not alone.

Currency

The trade of goods and services between states necessitates the exchange of currency. The translation of currency plays an integral role in a successful trade relationship. Currency exchange rates (and controls thereof) therefore represent significant influences on aggregate supply.

As stated earlier, an imbalance between large quantities of money and short supply creates inflationary circumstances. If private demand for currency exceeds supply (with domestic central banks making up the difference); that currency is said to be overvalued. This element can wreak havoc on trade relationships for a number of reasons.

• First, as Edna Carew suggests, traders and speculators would be wary of buying currency that is likely to fall (or slough).
• Second, foreign exporters would be unlikely to make payments using their own currency, as that currency would likely be used to offset the differential between the current exchange rate and the actual value of that currency (Carew, 1988).

After the end of World War I, the issue of overvalued currency remained a latent concern for redeveloping countries (including the industrialized European states). Popular belief, which carried into post-World War II reconstruction efforts as well, held that any policy response that entailed devaluation was a recipe for disaster. "Devaluation raises the domestic prices of imports and of exports …" warned one expert, adding, "[it] will tend to raise the prices of import substitutes, of potential exports, and of intermediate goods required for their production" (Sohmen, 1958).

Nevertheless, devaluation (particularly in light of a currency's overvaluation) remains a viable option for those countries seeking to tighten trade relationships and reemerge from economic malaise and/or collapse. In Latvia, this issue has reached a near boiling point in light of an account deficit of over 25 percent of the country's gross domestic product (GDP). With a heavy reliance on the euro as a borrowing currency, fears abound that any attempt at devaluation of the lat will exacerbate inflation and reduce the country's competitiveness. Devaluation at this point might seem a bit premature, as the government has just initiated anti-inflation policies which could help mitigate the lat's collapse. Although the concern is very real and widespread, Latvia's response is to hang on to its anti-inflation plan before further taking down an already weak currency (Central Europe and Baltic States, 2002).

Latvia's fear is based in part on the recent currency woes of Iceland, which in 2006 downgraded the krone about eight percent in only a few days (Chapman, 2006). Although Iceland is a small country with an equally small economy, such a devaluation created a ripple effect throughout the North Atlantic and Scandinavian region, with investors pulling out of risky ventures in that area. Developing nations like those in the Baltics, unfortunately, fall into this category.

As mentioned earlier, the supply side of international trade is very sensitive. Take, for example, the depreciation of the Thai baht, which in the late 1990s fell suddenly and appreciably, sending shockwaves throughout East Asia (Zhao, 2007). Even more painful was the 1998 devaluation of the Russian ruble, which in one month fell between 200 and 300 percent — former Soviet satellites who, while politically independent, continued to share 80 to 90 percent of their trade with Russia, were left reeling in fiscal crisis (Perekhodtsev, 1999). Clearly, in a global economy that relies on trade, any currency shock that occurs in one nation affects regional (and even far-reaching) trade partners.

Tariffs

Developing economies simply may not be able to offer a counterbalance to a dynamic potential trade partner or market. Still, they may possess goods or services that are in high demand (and which, therefore, trade partners may be willing and flexible in their price requirements). In these cases, protections applied to those markets, while isolating the fledgling economy from trading on a large scale, may allow infrastructures to grow at a manageable pace and protect demand-side interests such as employment, domestic taxation and pricing.

It goes without saying that such protectionist policies are not advisable for nations or trading blocs with little clout. However, evidence shows that a viable market, whether in a dominating economy or in a relatively small system, may be able to implement regulations that safeguard domestic systems and industries. These restrictions usually come in the form of tariffs.

In the post-war era, few countries have demonstrated the sort of "economic split personality syndrome" that has been manifest in China. Since 1949's communist revolution, that nation has vacillated between strict adherence to Maoist rhetorical dogma and cultivation of a pro-business, free market regime. However, since Mao Tse-Tung's death in 1976, China has grown to be one of the world's most powerful economies. Despite the sheer immensity of the Chinese markets, however, China has maintained a somewhat unpredictable status in international trade. In one recent example, China, which has a reputation as an area in which products are manufactured inexpensively (and therefore is considered fertile ground for international businesses), has been accused of unfairly blocking foreign-made car parts. The US (with which China shares "most favored nation" status) and the European Union (EU) take exception to a recently adopted regulation in China that states that "if the value of all imported automobile parts accounts for more than 60% of the value of the whole vehicle, it should be subjected to the import tariff as a 'whole vehicle'" (Lazell, 2006). China has also imposed tariffs designed to encourage domestic high-end steel producers to keep selling in-country rather than going abroad. That tariff amounted to a 17 percent tax on exported steel (Euromoney Institutional Investor PLC, 2005). Indeed, given China's capabilities and resources (both natural and capital), that nation has proven the viability of protectionist practices, especially in light of the continued and extensive trade relationships shared with the economic powerhouses of the West.

Of course, some tariffs are imposed with little international finger-pointing. In Europe, for example, a number of "innovative" tariffs have been imposed on utility prices. Since the products, electricity and natural gas, are the same in the UK as they are in EU nations, the price for each should be the same. However, the UK imposes a number of capped tariffs (taxes that remain at a certain rate for a particular period of time) and environmental assessments, some of which are duplicated in other EU partner states in varying numbers, others which are not. Furthermore, some EU countries' utilities combine energy with telecommunications, offering varying services (and associated taxes). Even relatively small nations like Portugal, Denmark and Sweden have been able to implement such tariffs on energy costs and not risk isolation (Market Watch: Energy, 2006). Rather, these trade restrictions and/or additional charges are viewed as simple variances in services whose positives and negatives are gauged as matters of consumer choice.

Exclusive Relationships

Earlier in this paper, this author briefly touched upon the trade relationship between the US and China. Under "Most Favored Nation" (MFN) status, two of the largest economies in the world, acknowledging their mutual interests and multifarious linkages, established an extensive arrangement in which free trade, in most situations, would occur. In other words, tariffs and similar trade barriers would be largely eschewed.

Such relationships are becoming more commonplace in the global marketplace. Under this sort of arrangement, the two (or more) participating countries create a level playing field under which goods and products are exchanged. The assumption that is made is that the participants are obliged to acknowledge parity in order for exchange to take place. It is in this equitable situation in which the details become murky, at least in a theoretical context. This nebulousness has become a thorn in the side of the World Trade Organization, as each individual MFN arrangement has different parameters and criteria for the nations to be "like" one another. As one observer writes, "like" has vexing connotations:

MFN and similar trade relationships, in light of the vagueness of the general guidelines (or lack thereof) under which such arrangements are established, can be a great benefit to any nation seeking to advance itself in a global market. The parameters for linking could be based on anything, including strategic and political relationships.

Conclusion

In macroeconomics, the casual observer might view the relationship between aggregate supply and demand as two separate arenas that, when balanced form the core of a successful domestic economy. However, the world is not comprised of wholly self-sufficient individual nations — there is another side to aggregate supply, an area affected by the demand of consumers in trade partner nations. International trade, which drives the global economy in a way it never did before the 20th century, has created interstate networks so intricate and numerous that a simple "supply-demand" portrait is thrown to the wind.

This statement is rooted in the fact that international trade entails one nation building and utilizing its aggregate supply (at least in part) to satisfy not domestic demand but the demand of foreign consumers. Hence, aggregate supply is in fact pulled in two sometimes competing directions. Japan's example at the beginning of this article is demonstrative of this fact. Japan opened its doors to American traders in the late 19th century, witnessing economic prosperity and rapid industrialization (predominantly in urban areas) as a result, but that industry was used for foreign trade and the military, not to satisfy domestic demand. Many scholars argue that the fact that Japan was focusing on establishing its international presence instead of the rampant rural poverty that existed at the time was a contributor to the war against the West. When the Depression took hold of the world, Japan (like most countries) looked inward to protect its infrastructure, employing strict tariffs and other restrictions to limit foreign imports. Isolated during the 1930s and 1940s, Japan reemerged on the world stage. However, for decades afterward, it retained many of the protectionist measures it began before the war; exporting inexpensive products and generating a massive monetary reserve overseas. Clearly, Japan's modern growth over the last century has been remarkable and yet illustrative of the sometimes conflicting pulls on supply caused by international trade.

Establishing trade relationships, particularly for those economies that are either reforming (as is the case in Latvia) or shifting priorities to seize on their potential on the world stage (China), can be vexing when one considers the pull on supply. In order to facilitate trade relationships (or at least level the playing field), nations that are at a competitive disadvantage may employ a number of tactics.

Currency Devaluation

The first of these policies is currency devaluation. Reducing the pressure on an overvalued currency, especially if anti-inflationary policies are in place (thus satisfying domestic demand), may prove viable. There is caution warranted, however, as unilateral devaluation can spark a chain reaction in areas in which interstate trade is heavy but fiscal instability exists. Latvia's potential of lowering the value of the lat could have an impact on the already fragile Baltic region, and this area has already experienced one currency sell off in recent years (Iceland), and the result of that action sent ripples throughout the North Atlantic.

Tariffs & Restrictions

The second action is one that any free market enthusiast abhors. Japan's wariness of opening its doors for foreign imports throughout the post-war period left partners crying foul about woefully unbalanced trade relationships. China's propensity for high tariffs and import restrictions has also created consternation in the international community. Still, there are instances, as the example of European utilities illustrates, in which tariffs and restrictions can alleviate supply pressures and appear less like a barrier and more like a matter of consumer choice.

Trading Blocks

Trading blocks or "most favored nation" relationships are a third approach. These arrangements provide an elite trading status between participating nations in which trade restrictions are limited or eliminated. The vagueness of the parameters of such relationships suggests that nations may see symbiotic potentials and even parity despite obvious economic differences between them. It is this parity that can generate strong revenues on either side of the agreement.

There is no "silver bullet" to addressing the sometimes conflicting relationship between aggregate supply, foreign demand and aggregate demand. There are conditions, however, in which certain measures may show success. Devaluation in an otherwise healthy economy (wherein inflation is held in check) may prove useful for Latvia without warding off foreign investment. Tariffs and protections, if applied in such a way that the foreign consumer is not impacted in an excessive manner, can ensure the long-term health of domestic infrastructure (and supply to meet the demands of that infrastructure). Finally, special relationships can create tight bonds between nations of varying size and resources, fostering economic growth on both sides without isolating domestic demand. Supply, pulled in two directions, may prove more flexible as a result.

Terms & Concepts

Aggregate Supply: The sum of all goods and services produced in a nation or system.

Currency Devaluation: Policy in which a currency's rate of exchange is lowered.

Foreign Demand: The sum of consumer expenditures, investment, goods and services to be met by foreign imports.

Inflation: An increase in prices instigated by a disproportionate rate of demand in relation to existing supply.

International Trade: Interstate relationship whereby goods and services are exported and imported by two or more national parties.

Most Favored Nation: Special trade relationship in which tariffs, trade barriers and restrictions are eliminated or exempted.

Tariff: Tax, charge or restriction on foreign imports.

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Suggested Reading

Chorev, N. (2007). A fluid divide: Domestic and international factors in US trade policy formation. Review of International Political Economy, 14, 653-689. Retrieved October 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26205317&site=bsi-live

Finger, J.M. & John S.W. (2007). Implementing a trade facilitation agreement in the WTO: What makes sense? Pacific Economic Review, 12, 335-355. Retrieved October 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25558831&site=bsi-live

Jensen, J., Rutherford, T. & Tarr, D. (2007). The Impact of liberalizing barriers to foreign direct investment in services: The case of Russian accession to the World Trade Organization. Review of Development Economics, 11, 482-506. Retrieved October 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25764943&site=bsi-live

Smith, J. (2007). The death of tariffs. Or not. World Trade, 20, 58. Retrieved October 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26543270&site=bsi-live