< Previous | Contents | Next >
In the advent of globalisation, where labour and capital mobility are high, international trade requires countries to engage in trade according to the resource endowments that they possess.
This is the theory of comparative advantage, where by nations engage in trade according to their resource rich capacities. For instance, India being rich in labour intensive production must export goods that are labour intensive and import goods in which it does not have a comparative advantage, capital-intensive goods in this case.
The relative differences in resource endowments then become the basis of trade for efficient allocation and utilisation of resources resulting in economic gains for trading countries.
In order to utilise resources most efficiently, external sector of a country becomes important. For example, foreign trade influences Indian aggregate demand in two ways. First, when Indians buy foreign goods, this spending escapes as a leakage from the circular flow, decreasing aggregate demand for domestically produced goods. Second, our exports to foreigners enter as an injection into the circular flow, increasing aggregate demand for domestically produced goods.