We have Y = C + I + G + X − M. So,
“If M↑, then Y↓. (If imports rise, then GDP falls.)” ✗
The above statement is a fallacy. Unfortunately, this fallacy is commonly taught by high-school economics teachers around the world.
Example. Suppose we initially have
$0 = C = I = G = X = M,
so that Y = $0. We now import $1 of Mamee from Malaysia (let’s say Ho Ching eats all of it). So, M = $1. Do we now have
Y = C + I + G + X − M = $0 + $0 + $0 + $0 − $1 = −$1?
Of course not.
GDP (Y) is total domestic value-added. When we import $1 of Mamee and Ho Ching eats it, we’ll also have C = $1. But this $1 wasn’t domestic value-added (instead, it was imported). So, we don’t want to count this $1 as part of GDP. Which is why we deduct M = $1:
Y = C + I + G + X − M = $1 + $0 + $0 + $0 − $1 = $0.
As expected, GDP (total domestic value-added) is $0 (the same as before). ∎
C + I + G + X must already contain all of M (see next post). But imports aren’t domestic value-added and shouldn’t be counted. This is the reason we deduct M.
Unfortunately, the above important point is rarely explained well (or at all).
This deficiency in understanding leads teachers and students to mindlessly take “Y = C + I + G + X − M” as some sort of mechanical formula (rather than an accounting identity that requires a little understanding). From this error, they are then easily led to the fallacy, “If M↑, then Y↓.”
we subtract imports to account for the fact that the good has already been counted … correctly calculated, imports don’t count negatively in GDP; rather, they have no impact on GDP …
Referring to a textbook “published by the National Council on Economic Education”, he writes,
At three different points, the lesson introduces a scenario that increases imports, and all three times the provided answer key informs teachers that GDP should decrease. … this lesson is likely used by high school teachers who often lack content knowledge in economics … and might fail to identify and correct the error.
2. Trump’s economic advisors, Peter Navarro and Wilbur Ross (2016) used this fallacy quite effectively for their purposes:
When net exports are negative, … this subtracts from growth …
In 2015, the US trade deficit … was … around $500 billion. Reducing this “trade deficit drag” would increase GDP growth.
3. This fallacy further reinforces nonsense about “injections” and “leakages”/”withdrawals”. See separate future post (coming “soon”).
4. The International Baccalaureate (IB) teaches this fallacy. Examples:
2019-05 S2 Markscheme (p. 9): increased import expenditure will reduce net exports, a component of AD, thus reducing AD and reducing economic growth.
2019-11 S2 Markscheme (p. 4): the trade deal could raise Japan’s exports by 29% but also increase EU imports by 34%, decreasing Japan’s net exports, a component of AD. This may decrease Japan’s real GDP
Millennia Institute 2016(?) H1 answers (p. 41): as imports increase, domestic firms will have to lay off workers as a result of fall in domestic output.
Victoria Junior College 2018 H2 Prelims Suggested answers: import expenditure decreasing … resulting in increases in AD and hence economic growth, assuming ceteris paribus.
5. Of course, actual economists rarely (or never) make this mistake. (I doubt Navarro actually believes some of the nonsense he says or writes.) But, as noted by Wolla, economists can help dispel this fallacy merely by exerting a little more effort and care in their teaching.