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A nation’s balance of trade, also called “net exports,” is a measure of the net flow of goods and services between that country and the rest of the world. Given domestic output (or income) (Y ), domestic spending on domestic output (D), exports (X ), and imports (M), the balance of trade is B = Y – D = X – M. The balance of trade is in surplus if B > 0, and it is in deficit if B < 0. This formulation suggests that fluctuations in domestic output can be absorbed by fluctuations in the trade balance, keeping domestic spending relatively stable. In 2005, the balances of trade relative to GDP (gross domestic product) for the United States, South Korea and Brazil was –5.7 percent, 2.6 percent, and 4.6 percent, respectively.
A nation’s income, the income of its trading partners, and the relative price of domestic goods (compared to foreign goods) determine its balance of trade. As domestic income (Y ) rises, expenditure on all goods—including foreign-produced goods—increases. Thus, imports increase and the balance of trade decreases. Similarly, when the income of a nation’s trading partners increases, so do its exports, thus increasing the balance of trade. The relative price (R) of domestic to foreign goods is R = SP/P*, where S is the spot exchange rate (the foreign currency price of the domestic currency) and P and P* denote the native currency prices of domestic and foreign goods, respectively. With short-run price inflexibility, a change in the exchange rate (S) is fully reflected in a change in the relative price.
Since domestic and foreign outputs have a degree of substitutability, the nominal exchange rate affects both exports and imports. Generally, an exchange-rate depreciation (a decrease in S) switches spending away from foreign goods toward domestic goods and increases the balance of trade.
Reflecting an excess of domestic spending over domestic income, a balance-of-trade deficit may be offset by a net inflow of labor and asset incomes from abroad. Otherwise, overspending must be funded through a depletion of national wealth, possibly in the form of increased indebtedness to foreign entities through the sale of domestic bonds or of outright sales of equity or other assets. This net inflow of foreign capital requires that foreign savers be willing to lend against, or buy, domestic assets. If they are unwilling to do so or if they are not allowed to do so because of domestic capital controls, the domestic currency will depreciate and eliminate the deficit. If this does not occur and if the exchange rate is fixed, the central monetary authority must sell its gold or foreign currency reserves, causing the domestic money supply and, over time, the domestic price level to decrease and reverse the deficit.
A nation may sustain a balance-of-trade deficit for short periods but not persistently. Rising indebtedness would cause foreign lenders to fear that their claims would not be honored, leading to a reduction of further investment in domestic assets. Moreover, the government’s corpus of gold and foreign currency reserves is finite. The existence of a long-term trade imbalance that is not offset by factor-income inflows is of concern because it reflects a fundamental divergence between domestic income and domestic spending. Many countries have learned, sometimes from bitter experience, that persistent failure to harmonize income and spending can lead to corrective forces, sometimes resulting in economic crises in the form of large increases in interest rates, unemployment, or a sharp depreciation of domestic currency.
Policymakers must balance short-run conflicts in maintaining the trade balance at a targeted level B* (possibly zero), while also maintaining domestic output at a level Y* consistent with full employment and constant inflation. In a fixed-exchange-rate regime, these goals can be met by judiciously mixing domestic demand and exchange-rate levels. Assuming stability, the relationships Y* = D + B (Y*, S) and B* = B (Y*, S) together yield unique values of domestic demand and exchange rate, D0 and S0, consistent with the goals. The level D0 is achieved by adjusting fiscal policy; monetary policy cannot be used independently under a fixed exchange rate regime.
It may be inferred that if fiscal policy is set at D0 but the exchange rate is overvalued (S > S0), a trade deficit will result, accompanied by unemployment. It may also be inferred that if the exchange rate is undervalued (S < S0), a trade surplus will accrue, along with inflationary pressure. Similarly, if the exchange rate is set at S0 but fiscal policy is too restrictive (D < D0), a trade surplus will coexist with unemployment, while an expansive fiscal policy (D > D0) results in a trade deficit and inflationary pressure.
If the exchange rate is flexible, both fiscal and monetary policies will quite likely affect the balance of trade. Both affect the interest rate (r) and, thereby, the exchange rate, which moves to equilibrate international asset markets by equating the expected returns on domestic and foreign assets. If the foreign interest rate exceeds the domestic interest rate, the difference is offset by an expected appreciation of the domestic currency; otherwise, the foreign asset yields excess returns. Given an unchanged expected future exchange rate, a decrease in r causes the domestic currency to depreciate (it decreases S) immediately, thus generating expectations of a forthcoming appreciation. The depreciation increases the balance of trade.
Fiscal and monetary expansions, by increasing Y, cause an incipient worsening of the trade balance, which works to depreciate the domestic currency. Additionally, a monetary expansion decreases r and causes capital outflows, compounding this depreciation and causing the balance of trade to improve. However, a fiscal expansion increases r, stimulates capital inflows, and appreciates domestic currency. The appreciation caused by sufficiently high capital mobility can overwhelm the depreciation effect of output expansion and worsen the balance of trade. Thus, a budget deficit can give rise to a trade deficit, invoking the label “twin deficits.”
- Appleyard, Dennis R., Alfred J. Field Jr., and Steven Cobb. International Economics. 5th ed. Boston: McGraw-Hill.
- Krugman, Paul R., and Maurice Obstfeld. 2006. International Economics: Theory and Policy. 7th ed. Boston: AddisonWesley.
- Mundell, Robert. 1963. Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. Canadian Journal of Economics and Political Science 29 (4): 475–485.
- Swan, Trevor W. 1963. Longer-Run Problems of the Balance of Payments. In The Australian Economy: A Volume of Readings, eds. H. W. Arndt and W. M. Corden, 384–395. Melbourne, Australia: F. W. Cheshire Press.
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