# 5. Foreign demand

Foreign trade is an essential part of the Danish economy. Exports are a key demand component and constitute about 50 per cent of GDP. An increase in foreign demand for Danish products creates opportunities for Danish firms to expand production, and employment increases in the short run. Table 5 presents the effects of a permanent 0.115 per cent increase in foreign demand without accompanying effects on foreign prices and foreign interest rates. The shock amounts to a 1000 million kroner increase in exports in 2005 prices in the first year.

Table 5. The effects of a permanent increase in foreign demand

Exports increase immediately reflecting the short-run coefficients for foreign demand in the export equations. The initial increase in exports is less than 1000 million as the average short run export demand elasticity is less than one. As a result, domestic production and employment expand. As production increases the demand for capital and other factors of production increases, and hence investment increases. The impact on private production is more direct. This is reflected on the higher accelerator impact on investment. Investments increase also due to the substitution effect.

The expansion of the domestic economy increases the export prices. This is because export prices are cost determined and the higher employment puts upward pressure on wages and hence the cost of production and prices rise. 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. Just like before wages increase more than the general price levels due to the deadweight from the non-responding exogenous import prices. This creates a real wage effect and real disposable and private consumption increase permanently.

The long-term positive effect on the balance of payments is a result of increased interest income from abroad. In contrast to the previous public demand shocks, it is now the foreign budget sector's balance that deteriorates permanently and 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 the balance of payments.

Figure 5. The effects of a permanent increase in foreign demand