Question

Trade with foreign governments can also affect the circular flow of income. Exporting goods to other nations can inject money into an economy, as one government makes an income by selling goods to another. However, importing goods can result in a withdrawal, as money is paid out to another nation in exchange for products. The sum total of injections and withdrawals affects the overall income of a nation. When the sum of government spending (G), exports (X), and investments (I) exceeds the sum of taxes (T), imports (M), and savings (S), the national income increases. When the reverse is true, the national income decreases.

–“The Circular Flow of Income”

How might a trade deal that allows two nations to freely exchange goods affect the circular flow of income?

Neither country is likely to experience a change in its economy.
One country is more likely than the other to see its economy expand.
The economies of both countries will likely grow due to an income increase.
The economies of both countries will likely slow down due to an income decrease.

Answer 1

The economies of both countries will likely grow due to an income increase.

Explanation: free trade raises both exports (injections) and imports (withdrawals), but by enabling specialization, larger markets, economies of scale and more efficient allocation of resources, trade generally increases total output and incomes in both countries. (It’s not guaranteed in every specific case if one country runs persistent net imports, but the typical effect is mutual income growth.)