Updated: Oct 23, 2018
Macroeconomic Analysis of Tariffs Pt. 4
Effects on Potential GDP
Net exports (NX) also equal the difference between the amount of saving (S) and investment (I) in an economy (NX = S – I). Imposing tariffs should increase net exports, all else being equal. As net exports rise, either savings must rise or investment must fall or both. Let’s consider each possible effect in turn.
Suppose savings rises one-for-one with the rise in net exports. What would be the effects of this? The savings (S) of an individual or a family is equal to their disposable income (Yd) minus their consumption (C), written S = Yd – C.
This is true for every individual in the economy and so it is also true for the economy as whole. Since the economy’s income, or GDP, doesn’t suddenly rise when a tariff is raised – and actually our analysis above suggests GDP growth likely decreases – then the only way savings can rise is if consumption falls.
Higher savings means lower consumption. And lower consumption of domestic goods and services means a decrease in aggregate demand. This will undo – at least to some extent – the increase in aggregate demand predicted earlier and hence undo its effects as well. To the extent that this happens, we predict the tariffs will not lead to any GDP growth and will more likely lead to a decline GDP growth.
Suppose instead that savings doesn’t change. In that case, as net exports rise, investment would have to decline one-for-one in order to maintain our fundamental macro relationship.
What is investment in a macro economy? “Investment” is the amount that businesses invest in new capital and equipment which includes things such as an economy’s new buildings, new roads, new computers, expanded production floors and so on. Those are the basic building blocks of an economy’s productive capacity.
When a business is investing in capital and equipment, it is buying more goods and services in the economy and hence expanding aggregate demand. So a decline in investment in an economy is also fundamentally a decline in aggregate demand in that economy too, again offsetting any stimulative effect on aggregate demand from the increase in net exports.
As a result, if investment declines, aggregate demand declines and the economy’s capital formation process will slow. Slower capital formation will fundamentally lower the economy’s long-term ability to produce more goods and services, what is called an economy’s “potential GDP”. And this will affect an economy for many years to come.
Savings and Investment in Conclusion
If tariffs decrease imports and exports don’t change, then net exports must rise. This is usually one goal of imposing tariffs in the first place (i.e., to eliminate or greatly reduce a trade deficit). It follows from the rise in net exports that either savings rise or investment drops or both. Both effects will lower aggregate demand. The more that investment adjusts, the worse the negative long-term effect is on the economy because it slows the capital formation process and hence lowers the economy’s potential GDP.
Reviewing all of the above we see that any increase in aggregate demand because of tariffs is tenuous at best. If net exports stimulate consumers to buy more domestic goods instead of foreign goods and hence boost aggregate demand, then the necessary increase in savings or the decline in investment will lower aggregate demand.
The direct effect of tariffs on aggregate supply is negative since it increases the costs of production. This decline in aggregate supply pushes up prices and down output (GDP or GDP growth). As people come to understand and expect higher prices and thus demand higher wages, the tariffs indirectly lead to higher labor costs across the economy which further lowers aggregate supply, further raising prices and lowering output (GDP).
Finally, to the extent investment declines, capital formation slows and this harms long run GDP and the economy’s potential GDP.