Key Concepts and Summary

Key Terms

balance of trade (trade balance) the gap, if any, between a nation’s exports and imports current account balance a broad measure of the balance of trade that includes trade in goods and services, as well as international flows of income and foreign aid exports of goods and services as a percentage of GDP the dollar value of exports divided by the dollar value of a country’s GDP financial capital the international flows of money that facilitates trade and investment merchandise trade balance the balance of trade looking only at goods national savings and investment identity the total of private savings and public savings (a government budget surplus) unilateral transfers “one-way payments” that governments, private entities, or individuals make that they sent abroad with nothing received in return

Key Concepts and Summary

10.1 Measuring Trade Balances

The trade balance measures the gap between a country’s exports and its imports. In most high-income economies, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services; however, most global trade still takes the form of goods rather than services. The current account balance includes the trade in goods, services, and money flowing into and out of a country from investments and unilateral transfers.

10.2 Trade Balances in Historical and International Context

The United States developed large trade surpluses in the early 1980s, swung back to a tiny trade surplus in 1991, and then had even larger trade deficits in the late 1990s and early 2000s. As we will see below, a trade deficit necessarily means a net inflow of financial capital from abroad, while a trade surplus necessarily means a net outflow of financial capital from an economy to other countries.

10.3 Trade Balances and Flows of Financial Capital

International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite and means the country is a net lender to the rest of the world.

10.4 The National Saving and Investment Identity

The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources. If S is private saving, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit: A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit), while economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit).

10.5 The Pros and Cons of Trade Deficits and Surpluses

Trade surpluses are no guarantee of economic health, and trade deficits are no guarantee of economic weakness. Either trade deficits or trade surpluses can work out well or poorly, depending on whether a government wisely invests the corresponding flows of financial capital.

10.6 The Difference between Level of Trade and the Trade Balance

There is a difference between the level of a country’s trade and the balance of trade. The government measures its level of trade by the percentage of exports out of GDP, or the size of the economy. Small economies that have nearby trading partners and a history of international trade will tend to have higher levels of trade. Larger economies with few nearby trading partners and a limited history of international trade will tend to have lower levels of trade. The level of trade is different from the trade balance. The level of trade depends on a country’s history of trade, its geography, and the size of its economy. A country’s balance of trade is the dollar difference between its exports and imports. Trade deficits and trade surpluses are not necessarily good or bad—it depends on the circumstances. Even if a country is borrowing, if it invests that money in productivity-boosting investments it can lead to an improvement in long-term economic growth.

Self-Check Questions

1 . If foreign investors buy more U.S. stocks and bonds, how would that show up in the current account balance? 2 . If the trade deficit of the United States increases, how is the current account balance affected? 3 . State whether each of the following events involves a financial flow to the Mexican economy or a financial flow out of the Mexican economy: a. Mexico imports services from Japan b. Mexico exports goods to Canada c. U.S. investors receive a return from past financial investments in Mexico 4 . In what way does comparing a country’s exports to GDP reflect its degree of globalization? 5 . At one point Canada’s GDP was $1,800 billion and its exports were $542 billion. What was Canada’s export ratio at this time? 6 . The GDP for the United States is $18,036 billion and its current account balance is –$484 billion. What percent of GDP is the current account balance? 7 . Why does the trade balance and the current account balance track so closely together over time? 8 . State whether each of the following events involves a financial flow to the U.S. economy or away from the U.S. economy: a. Export sales to Germany b. Returns paid on past U.S. financial investments in Brazil c. Foreign aid from the U.S. government to Egypt d. Imported oil from the Russian Federation e. Japanese investors buying U.S. real estate 9 . How does the bottom portion of Figure 10.3, showing the international flow of investments and capital, differ from the upper portion? 10 . Explain the relationship between a current account deficit or surplus and the flow of funds. 11 . Using the national savings and investment identity, explain how each of the following changes (ceteris paribus) will increase or decrease the trade balance: a. A lower domestic savings rate b. The government changes from running a budget surplus to running a budget deficit c. The rate of domestic investment surges