BALANCE OF TRADE



Balance Of Trade 117
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The balance of trade of a nation is the difference between values of its exports and imports. When exports are greater than imports, the nation is said to have a balance of trade surplus. On the other hand, if imports are greater than exports, the nation is said to have a balance of trade deficit. Exports and imports that figure in the balance of trade concept arise in the context of trade with other countries. Exports are the value of goods and services produced in the United States and sold to other countries—in other words, exports are expenditures on American goods and services by the residents of foreign countries. A Jeep Cherokee produced in Detroit and sold to a Canadian resident in Toronto is an example of a U.S. export. Imports, on the other hand, are the value of goods and services produced in other countries and bought by the United States—in other words, imports are expenditures by the residents of the United States on goods and services produced by foreign countries. A Sony television manufactured in Japan and bought by an American living in Los Angeles is an example of a U.S. import. Since the balance of trade arises in the context of foreign trade, the balance of trade surplus is also called the foreign trade surplus and the balance of trade deficit is also called the foreign trade deficit. Also, since the balance of trade surplus or deficit is defined as the difference between exports and imports, it as also called net exports.

The foreign trade surplus or deficit is considered to play an important part in the economic growth of a nation, and thus it has implications for jobs created within the country or jobs lost to other nations. As a result, this topic is often debated in an emotionally charged atmosphere. Below is a brief history of balance of trade in the United States, as well as a summary of the economic implications of running a foreign trade surplus or deficit.

THE RISE AND FALL OF THE U.S. TRADE
DEFICIT

Up until 1982, the foreign trade deficit was not a serious problem for the United States. The trade deficit started rising dramatically in 1983, from about $38 billion in 1982 to a peak of approximately $170 billion in 1987. Moreover, the trade deficit has remained at relatively high levels since 1982—hovering well over $100 billion per year for most of the 1988-98 period.

One of the reasons for the emergence of the balance of trade deficit in 1983-84 was the increase in interest rates in the United States. The early 1980s experienced higher nominal interest rates (the ordinary interest rates as quoted by financial institutions) and higher real interest rates (nominal interest rates when adjusted for inflation). The interest rate is one of the major determinants of the exchange rate. The exchange rate, in turn, is the value of the U.S. dollar in relation to the currencies of other countries—often, it is expressed as the value of one U.S. dollar in terms of the number of units of the currency of another nation. For example, if one U.S. dollar is equal to 100 Japanese yen (the Japanese currency), then the exchange rate between the U.S. dollar and the Japanese yen is 1:100. Of course, the exchange rate of the U.S. dollar can also be expressed the other way around—that is, the number of U.S. dollars equal to one Japanese yen. The U.S. dollar will be characterized as being strong in relation to the Japanese yen if a large number of yens are equal to one U.S. dollar, whereas the dollar will be considered weak if one U.S. dollar equals fewer yens.

The exchange rate is like the price of any commodity that responds to forces of demand and supply. If the demand for the U.S. dollar rises relative to another currency, its price in terms of that currency rises—that is, the exchange rate (of the dollar) appreciates. On the other hand, if the supply for the U.S. dollar rises relative to another currency, its price in terms of that currency falls—that is, the exchange rate (of the dollar) depreciates. The rise in interest rates experienced in the United States during the early 1980s made investment in the United States more attractive, relative to investments in other countries. As a result, foreign residents rushed to convert their financial assets (held in their own domestic currencies) into U.S. dollars for investment in the United States. This raised the demand for the U.S. dollar and the supply of foreign currencies, raising the value of the U.S. dollar. This appreciation in the U.S. dollar had adverse effects on the U.S. foreign trade deficit, since it reduced U.S. exports to other countries and increased imports from these countries.

The way changes in the exchange rate affect exports and imports can be briefly explained as follows. When the U.S. dollar appreciates, foreign goods (expressed in U.S. dollars) become cheaper and U.S. goods (expressed in foreign currencies) become more expensive. Assume, for example, that one U.S. dollar was equal to 100 Japanese yen and a Sony television is priced at 15,000 yen in Japan—implying that the television is worth $150 in the United States. Now, assume that the U.S. dollar appreciates so that one dollar equals to 150 yen. The stronger dollar implies that the Sony television set will now cost only $100 in the United States. The lower price of the television set (in terms of the U.S. dollar) leads to increased sales of Sony television sets in the United States—that is, an increase in imports into the United States. Now, consider an item that the United States exports, for example, a Jeep Cherokee. Suppose that the Jeep costs $10,000 in the United States. When one dollar equals to 100 yen, a Jeep Cherokee will sell for 1,000,000 yen in Japan. When the U.S. dollar appreciates to 150 yen to a dollar, the Jeep will sell for 1,500,000 yen in Japan. Thus, due to the appreciation of the U.S. dollar, a Jeep Cherokee becomes more expensive in Japan, reducing its demand—this translates into reduced exports from the United States. The exchange rate appreciation thus serves as the double-edged sword—reducing exports and increasing imports simultaneously. This is what happened in the 1980s; the rise in the value of the U.S. dollar was the main culprit behind the dramatic rise in the U.S. foreign trade deficit. The U.S. dollar has gradually declined in value(with significant fluctuations) since then, as has the trade deficit, but not to the level that existed in 1982.

THE U.S. BUDGET AND TRADE DEFICITS.

For most of the 1980s, the U.S. economy faced both federal budget deficits and foreign trade deficits, often called the twin deficits. This was, however, no mere coincidence. As explained above, higher interest rates had pushed up the foreign exchange rate and the foreign trade deficit increased dramatically. Higher interest rates in the United States were, in turn, at least partly, caused by the U.S. budget deficit. An existence of a budget deficit implies that the government is spending more than it is receiving in tax revenue. As a result, the government has to borrow to meet the shortfall in tax revenue. Such government borrowing adds to the demand for credit in the debt (financial) market, which, in turn, raises the cost of borrowing, the interest rate. This phenomenon is often called the international crowding out. U.S. budget deficits were in large part financed by investors from abroad (lured by higher interest rates in the United States relative to interest rates in their home countries). Thus, the simultaneous existence of budget and trade deficits appeared convenient and painless for the U.S. economy—the overspending on foreign goods and services (the negative net exports) were largely financed by borrowing from abroad.

This seemingly odd arrangement works as follows. The United States needs to pay for importing more than exporting (equal to the value of net exports). When foreign nationals invest in the United States by buying U.S. Treasury bonds, they lend funds to the U.S. government to finance the federal budget deficits. This inflow of funds from foreign nationals to buy the Treasury bonds (called the inflow of capital and deemed to be a part of the capital account), however, offsets the outflow of funds from the United States that would have been necessary to pay for the excess of imports over exports (often referred to as activities on the current account). The need for the payment by the United States on account of the current account is avoided due to the offsetting transaction on the capital account. Nevertheless, the net result of the twin deficits was that the U.S. dependence on foreign funds grew, and so did the U.S. foreign debt. In fact, the United States turned into a debtor nation for the first time during the Reagan administration—that is, the United States owed more to other countries than other nations owed to the United States. Foreign debt is not simply a matter of national prestige. It has certain economic implications. Sudden withdrawal of funds from the United States, by foreign nationals (for example, due to a lack of confidence in U.S. currency), can destabilize the U.S. and world financial markets.

During the late 1990s, while the United States has continued to experience a trade deficit of over $100 billion a year, the fiscal budget has started to have a surplus. The interest rates are low as well. Thus, interest rates can no longer be held as being primarily responsible for the trade deficit. It is now the growing U.S. economy and mediocre foreign economies that are the main culprits. Factors determining the balance of trade are explained as follows.

DETERMINANTS OF THE BALANCE OF
TRADE

There are three major determinants of the trade balance or net exports: Foreign exchange rates, national incomes, and domestic and foreign price levels.

EFFECTS OF THE FOREIGN EXCHANGE RATE.

The way the foreign exchange rate affects exports and imports has already been discussed in fair detail. In a nutshell, if the U.S. dollar appreciates (the dollar becomes stronger and the foreign exchange rate increases), exports decline and imports increase, causing the foreign trade deficit to rise. If the dollar depreciates (the dollar becomes weaker and the foreign exchange rate decreases), the foreign trade deficit falls.

EFFECTS OF CHANGES IN DOMESTIC AND FOREIGN
INCOMES.

Changes in national incomes in foreign countries as well as in the United States have an important effect on net exports. If national incomes in foreign countries rise, foreign residents demand greater amounts of goods and services, some of which can be bought from the United States. As a result, an increase in incomes in foreign countries leads to an increase in U.S. exports, causing the foreign trade deficit to rise (assuming other factors do not change). If national incomes in foreign countries fall, U.S. exports to these countries will decline, leading to a decline in the foreign trade deficit as well.

If the U.S. national income rises, U.S. consumers demand more goods and services, and some of this increased demand is for goods and services produced in other countries. As a result, a rise in U.S. income increases U.S. imports, causing the foreign trade deficit to rise. On the other hand, if the U.S. national income declines, the demand for goods and services by U.S. consumers falls, so does the demand for imported goods and services—this leads to a decrease in the foreign trade deficit.

From the preceding discussion, it follows that changes in net exports are also tied to rates of economic growth, both home and abroad. While U.S. policy makers have some control over the rate of economic growth in the United States, they cannot unilaterally influence rates of economic growth in foreign countries. As a result, U.S. policy makers do not have complete control of the behavior of U.S. net exports.

PRICES IN THE UNITED STATES AND IN FOREIGN COUNTRIES.

Even if the foreign exchange rate and the domestic and foreign economic growth rates remain unchanged, changes in price levels can affect U.S. net exports. Let us first look at the effects of a change in the price level in the United States. Suppose that the U.S. inflation rate is equal to 10 percent per annum. This means that prices of goods and services in the United States are rising at the annual rate of 10 percent, on average. As a result, a Jeep Cherokee that costs $10,000 this year will cost $11,000 next year. Also, let us assume that foreign prices do not change and that one U.S. dollar is equal to 100 Japanese yen, and this exchange rate will not change next year. Now, look at the effect of the U.S. price increase on the price of a Jeep Cherokee in terms of Japanese yen, the price most relevant to a prospective Japanese buyer of a Jeep Cherokee. This year the Jeep Cherokee costs 1,000,000 yen ($10,000 × 100) to a Japanese buyer, but it will cost 1,100,000 yen next year. Due to an increase in the price in yen, the export of Jeep Cherokees to Japan would decline as the demand for the vehicle declines in Japan (given that other factors do not change). Thus, in general, an increase in U.S. price levels will hurt U.S. exports.

An increase in U.S. price levels will also affect U.S. imports of foreign goods and services. In the above example, we assume that the U.S. price level rises and the Japanese price level does not. Thus, a Japanese-made Toyota costs the same amount in U.S. dollars this year as it will next year (since the foreign exchange rate is also assumed to remain unchanged), but a Jeep Cherokee sold in the United States will cost 10 percent more. This implies that the next year, a Japanese-made Toyota will become cheaper relative to a Jeep Cherokee—thus, a Toyota will become relatively more attractive to a prospective U.S. car buyer the next year. In general, therefore, U.S. price increases also increase U.S. imports. The price increases serve as a double-edged sword that reduces exports and increase imports simultaneously, causing net exports to decline—that is, the foreign trade deficit becomes worse or the magnitude of the foreign trade surplus declines.

One can see that changes in foreign price levels will have analogous effects. If foreign prices increase and the U.S. price level does not increase (given that other factors do not change also), U.S. exports will rise and imports will fall, causing the U.S. foreign trade deficit to shrink or the foreign trade surplus to grow, as the case may be.

ECONOMIC IMPLICATIONS OF FOREIGN
TRADE DEFICITS

As alluded to in a previous section, increasing U.S. foreign trade deficits contributed, at least passively, to mounting U.S. foreign debts, with implications for the stability of U.S. financial markets. Foreign trade deficits have other serious economic implications.

A COMPONENT OF AGGREGATE DEMAND.

When exports exceed imports, it implies that foreign demand for U.S. goods and services is greater than U.S. demand for goods and services of other countries. In other words, there is a net positive demand for U.S. goods and services from abroad. The foreign demand adds to the total domestic demand from all sectors—primarily, made up of consumer spending, business investment, and government spending on goods and services. Thus, a net positive foreign demand augments the aggregate demand for U.S. goods and services. The aggregate demand is simply the sum of consumer spending, business investment, government spending, and net exports. An increase in the aggregate demand, due to positive net exports, has roughly the same implications for the U.S. economy as an increase in one of the other three components of the aggregate demand.

On the other hand, when imports exceed exports, it implies that foreign demand for U.S. goods and services is less than U.S. demand for goods and services of other countries. In other words, there is a net negative demand for U.S. goods and services from abroad. The net negative foreign demand subtracts from the total domestic demand from all sectors. Thus, a net negative foreign demand reduces the aggregate demand for U.S. goods and services. A decrease in the aggregate demand, due to negative net exports, has roughly the same implications for the U.S. economy as a reduction in one of the other three components of the aggregate demand.

There are three major effects on the economy of an increase or decrease in the aggregate demand: (1) it affects the output and income in the economy; (2) it influences the level of employment and unemployment in the economy; and (3) it affects the price level and the inflation rate in the economy.

NET EXPORTS AND THE OUTPUT AND INCOME IN
THE ECONOMY.

When an increase in net exports leads to an increase in the aggregate demand, it also increases the output (often called the real gross domestic product or real GDP) and income (often called the real national income) in the economy. This can be explained in terms of Keynesian macroeconomic theory. When aggregate demand in the economy increases, producers increase the output of goods and services to meet the increased demand. The increased production of goods and services in the economy generates additional income in the economy. Thus, net exports can be a source of economic growth for an economy. If the economy is very large, relative to the magnitude of the change in the net exports, effects of changes in net exports may not be very conspicuous. Nevertheless, an export-dependent small economy can experience visible influences on its economic growth if net exports increase sharply. The Taiwanese economy provides a good example of such an economy where growth in the aggregate demand was fueled by exports to other countries.

Just as an increase in net exports has favorable effects on the economic growth of a nation, a decrease in net exports will have the opposite effect on the growth of its output and income.

NET EXPORTS AND THE EMPLOYMENT LEVEL.

The fact that changes in net exports have an effect on the economy's GDP and economic growth has an obvious implication for the employment level in the economy. If, for example, net exports in the United States increase and the output of U.S. goods and services increases as a result, producers will need to hire more workers in order to increase output which, in turn, raises the level of employment of the workforce. This normally translates into a lower unemployment rate in the economy, a much sought after economic outcome. It is true, however, that the employment level may increase only with a lag—as the aggregate demand level rises (such as due to an increase in net exports) in the economy, producers first resort to the use of overtime from existing workers before adding to the number of workers employed. Once the increase in the aggregate demand level is deemed to be relatively permanent, however, they hire additional permanent workers.

A decrease in net exports will have the opposite effect on the level of employment in the economy—a reduction in net exports leads to a decline in aggregate demand and a consequent decrease in output and employment.

NET EXPORTS AND THE PRICE LEVEL.

A rise in net exports is mixed blessing. While an increase in the foreign trade balance leads to an increase in GDP, spurs economic growth, and generates jobs, it is also deemed to be inflationary. When net exports rise, the aggregate demand for goods and services increases. As producers rush to increase production to meet the increased demand, they put an upward pressure on wages and other input prices, leading to an increase in the cost of production. An increase in the cost of production, in turn, leads to an increase in the retail prices of goods and services paid by domestic consumers. In addition to the upward pressure put on the domestic prices due to an increase in the cost of production, an increase in foreign demand for U.S. goods makes U.S. producers of these goods more tempted to increase the prices of these products. Overall, an increase in net exports will tend to put an upward pressure on the domestic price level—the extent of the price increase will depend on how far the economy is from full employment. The U.S. economy is considered to have achieved the full employment, or the potential output level, when the economy experiences a 6 percent rate of unemployment and a plant capacity utilization rate of 86 percent. The closer the economy is to full employment, the greater is the pressure on the price level.

A decline in net exports or a shrinking foreign trade balance has the opposite effect on the domestic price level—it puts downward pressure on the price level. A decline in net exports leads to a decline in aggregate demand in the economy. This puts downward pressure on the domestic price level for two reasons—it puts a downward pressure on the cost of production, and it makes it harder for the domestic producers to raise the prices of their products.

As is apparent from the preceding discussion, a rising foreign trade deficit is rather good from the point of view of individual consumers—they end up paying lower prices for goods at the retail level (presumably, they also have a wider choice of products, since more foreign products, and greater quantities of them, are available).

MACROECONOMIC POLICIES AND THE FOREIGN TRADE DEFICIT.

All capitalist economies, including the United States, attempt to stabilize the economy around full employment, using monetary and fiscal policies. Nevertheless, a macroeconomic policy that is good for the domestic economy does not necessarily improve the foreign trade balance. Consider, for example, that the United States conducts expansionary monetary policy that raises the domestic aggregate demand (by spurring domestic consumption and investment). Since the monetary policy leads to an economic expansion, output and income rise in the United States. This rise in the U.S. income, in turn, generates greater demand for imported goods, causing an existing foreign trade deficit to become worse. Thus, policy makers often face a policy dilemma—the possible adverse effects of a macroeconomic policy on the foreign trade balance.

THE POLITICS AND ECONOMICS OF
FOREIGN TRADE

As is clear from the preceding discussions, foreign trade, even if it results in a deficit on the foreign trade balance, is not all bad. While a foreign trade deficit can be held responsible for some lost jobs, it also provides consumers with lower prices and greater choice. Debate on the foreign trade deficit in the popular media is often unbalanced. During the North American Free Trade Agreement debates in the United States, opponents of the agreement put a lot of emphasis on the "sucking sounds" of jobs lost to Mexico. The trade deficit with Japan is also often debated in a politically charged atmosphere, frequently resulting in Japan-bashing. Recently, the attention has turned to the trade imbalance with the People's Republic of China.

A foreign trade deficit essentially creates a classic conflict between two groups—workers and consumers. Workers as a group may tend to lose due to lost jobs (but not all workers lose since jobs are created in import-related industries). Consumers, on the other hand, gain as explained above. Which group's interest will the government keep in mind in dealing with trade issues? The answer to this question often boils down to whichever group has the greater political influence. It so happens that workers tend to be better organized and they are, thus, able to influence government trade policy in their favor.

[ Anandi P. Sahu Ph.D. ]

FURTHER READING:

Froyen, Richard T. Macroeconomics: Theories and Policies. 6th ed. Upper Saddle River, NJ: Prentice Hall, 1998.

Gordon, Robert J. Macroeconomics. 7th ed. Reading, MA: Addison-Wesley, 1998.



Also read article about Balance of Trade from Wikipedia

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