4. Foreign demand

The focus now shifts from the public sector to the foreign sector. Foreign trade is an essential part of the Danish economy. Exports are a key demand component and constitute about 50 percent of GDP. An increase in foreign demand for Danish products makes Danish firms expand production, and creates a positive impact on employment in the short run.

 

Table 5 presents the effects of a permanent increase in foreign demand without accompanying effects on foreign prices and foreign interest rates. The shock amounts to 0.1 percent of GDP in 2010 prices in the first year. (See experiment)

 

Table 4. The effect of a permanent increase in foreign demand

    1. yr 2. yr 3. yr 4. yr 5. yr 10. yr 15. yr 20. yr 25. yr 30. yr
    Million 2010-Dkr.
Priv. consumption fCp 107 414 622 703 738 865 1020 1078 1066 1058
Pub. consumption fCo -17 -29 -38 -42 -44 -41 -38 -33 -29 -29
Investment fI 459 708 574 538 492 343 199 84 16 12
Export fE 1435 1435 1481 1466 1453 1185 849 665 708 936
Import fM 977 1237 1311 1327 1334 1392 1424 1449 1518 1665
GDP fY 1096 1344 1380 1384 1347 965 573 293 192 276
    1000 Persons
Employment Q 0.92 1.34 1.54 1.59 1.56 0.92 0.21 -0.26 -0.43 -0.36
Unemployment Ul -0.52 -0.69 -0.77 -0.80 -0.78 -0.47 -0.11 0.13 0.22 0.18
    Percent of GDP
Pub. budget balance Tfn_o/Y 0.02 0.03 0.03 0.03 0.03 0.02 0.02 0.01 0.01 0.01
Priv. saving surplus Tfn_hc/Y 0.00 -0.02 -0.02 -0.02 -0.02 -0.01 -0.01 0.00 0.00 0.00
Balance of payments Enl/Y 0.02 0.01 0.01 0.01 0.01 0.02 0.01 0.01 0.01 0.01
Foreign receivables Wnnb_e/Y -0.02 -0.01 0.00 0.02 0.03 0.11 0.16 0.19 0.21 0.24
Bond debt Wbd_os_z/Y -0.03 -0.06 -0.09 -0.12 -0.15 -0.27 -0.31 -0.32 -0.31 -0.31
    Percent
Capital intensity fKn/fX -0.05 -0.06 -0.05 -0.04 -0.03 0.01 0.03 0.04 0.04 0.03
Labour intensity hq/fX -0.03 -0.03 -0.02 -0.02 -0.01 -0.01 -0.01 -0.01 -0.02 -0.02
User cost uim 0.00 0.00 0.01 0.01 0.02 0.05 0.06 0.07 0.06 0.05
Wage lna 0.01 0.02 0.04 0.06 0.08 0.15 0.18 0.18 0.17 0.14
Consumption price pcp 0.00 0.01 0.01 0.02 0.02 0.06 0.07 0.08 0.08 0.07
Terms of trade bpe 0.00 0.00 0.01 0.01 0.02 0.03 0.04 0.04 0.04 0.04
    Percentage-point
Consumption ratio bcp -0.03 -0.01 0.00 0.01 0.01 0.00 0.00 0.01 0.01 0.01
Wage share byw -0.01 0.00 0.00 0.01 0.01 0.03 0.03 0.02 0.02 0.01

(See details)

 

Exports immediately increase relative to the baseline reflecting the positive shock in foreign demand. The higher exports make domestic production and employment expand, due to the income multiplier process. The income multiplier refers to the final change in income as compared to the injection of capital deposits or investments which originally fueled the growth.  In the present experiment, the income multiplier can be seen as the ratio between the effects on final demand and the change in foreign demand. The ADAM multiplier for GDP remains less than one because higher demand triggers not only GDP but also imports, see ADAM book for further discussion. As production expands the demand for capital and other factors of production increases, and hence investment increases relative to the baseline. This is reflected on the higher accelerator effect on investment. The accelerator effect is when an increase in production results in a proportionately larger rise in investment. An ‘x’ percent increase in production requires an ‘x’ percent increase in capital. Since capital stock is larger than annual investment, ‘x’ percent increase in capital requires a more than ‘x’ percent increase in investment. Investments increase also due to the substitution effect. A substitution effect arises when a change in the relative prices of factors induces producers to use more of a relatively cheaper factor and less of a relatively more expensive factor.

 

The expansion of the domestic economy increases the export prices relative to the baseline. This is because export prices reflect production cost and the higher employment puts upward pressure on wages and hence on the cost of production. As prices grow relative to the baseline, competitiveness worsens, which dampens exports and stimulates imports. Because of this the long term effect on export volumes is smaller than the initial export demand shock, see more about the crowding out process in section 1. Private consumption increases permanently due to the positive real wage effect. Real wage effect arises because wages increase/decrease more than the general price levels due to the deadweight from the non-responding exogenous import prices. This creates a positive/negative real wage effect and real disposable income and private consumption increase/decrease permanently.

 

Imports also expand due to an increase in domestic economic activity in the short run. The higher export prices increase earnings from exports, but higher imports have a negative effect on the trade balance. The net result is a small improvement in the trade balance.

 

The long-term positive effect on the balance of payments is also a result of higher interest income from abroad. In contrast to the previous public demand shocks, it is now the budget balance of the foreign sector that deteriorates permanently while the public budget balance improves in the long term. It is not necessary to consider a tax increase in order to keep public debt unchanged. On the contrary, it is possible to loosen the fiscal policy slightly. In general, higher foreign demand is a demand shock similar to higher government purchases, but the shocks differ considerably concerning their long-term effects on public budget sustainability and on the balance of payments.

 

Figure 4. The effect of a permanent increase in foreign demand

 

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