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Economics: Trade Balances

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About this Lesson

  • Type: Video Tutorial
  • Length: 15:24
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 165 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: International Focus (25 lessons, $43.56)
Economics: Exports, Imports, and Accounting (4 lessons, $8.91)

This economics video lesson will teach you about Trade Balances. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Thinkwell
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If you read the newspaper and listen to the radio, you'll frequently hear stories about the trade deficit. The trade deficit is at record levels, and often this fact is announced with some alarm, as if you should be concerned. Well, what is the trade deficit and is it something we should worry about? We're going to discuss now what the trade deficit is, what its relationship is to the rest of the economy and how particular government policies can influence the trade deficit. Let's begin with a simple definition.
The trade deficit is simply the excess of imports of goods and services over exports of goods and services. So for instance, if our economy is spending $3 billion importing goods and services and we're only exporting $2 billion worth of goods and services, we've got a trade deficit. It's the excess of imports over exports. Now, the first question to ask yourself is, "How are we able to import more than we export," because our exports presumably are paying for our imports. That's the way the current account works. However, it's possible that foreigners are lending us the money that enables us to buy more of their stuff than they're buying of our stuff. It is likely that this deficit on the current account is offset by a surplus on the capital account. Foreigners sell us stuff in exchange for our IOUs and what makes this all work out is that foreigners acquire our IOUs. They are lending us the money that makes it possible for us to run a trade deficit. So foreigners acquire our assets as we import more from them than we export to them. The current account deficit is offset by a capital account surplus.
So this helps put the trade deficit in perspective. The trade deficit is simply our borrowing from foreign countries, so that we can buy more from them than they buy from us. Now, is that bad? Well, like any debt, it can be one of two stories. First of all, think about your own trade deficit. You're running a trade deficit. You are spending more money than you're taking in. You are buying more than you're selling right now, and the way you're doing it is you're taking out student loans. Well, is that a good thing? Absolutely, because you're using this money to invest in human capital, which is going to make you more productive in the long-run and enable you to pay back the loans with interest and still have a lot of good stuff left over. So whenever you're running a deficit or acquiring debt in order to invest in productive capacity, that's a good business move. On the other hand, suppose you were borrowing money to drink a lot of French champagne and play a lot of pinball. That might be fun, but you're setting up trouble, because, in the long-run, you're not going to have any additional productive capacity with which to pay off those debts. What you're doing is you are spending the money you borrow on pure consumption in that case, and therefore you're setting up a situation where, in the long run, you're going to have to default or experience a lot of pain to pay off this debt. So debt is good if it's financing the creation of productive capacity. If debt is being used to acquire assets that make it possible for you to repay the debt, that's good. But if you're wasting the money, that's bad. Think about all the people right now who are running up their credit cards to buy consumer goods and services. The concern is that they're acquiring a lot of debt that they're not going to be able to pay off and the inevitable result is bankruptcy. On the other hand, small businesses that borrow money to invest in a taco stand, for instance, that's going to make a profit and allow them to pay off the debt, by all means, they should borrow the money, because, if they didn't, the taco stand wouldn't get opened and the productive capacity would never happen. The opportunity would be lost.
So a trade deficit is only bad if it's used purely for consumption and not to create productive assets. If we're borrowing money so that we can put computers in our factories to increase our capacity in the long run to produce goods and services, the grade deficit is a good thing for our country. And that's why a lot of developing countries run trade deficits, because they are acquiring the investment goods that, in the long run, are going to make them productive.
Now, let's think a little bit more about the trade deficit and its connection to the rest of the economy. You've seen these two equations before, let's use them again. Here are all the ways in which you can use income: consumption, savings, or paying taxes. Here are all of the forms of aggregate expenditure that add up to make total income in the economy: consumer spending, business spending, government spending and the spending of foreigners, our net exports. Well, if we set Y equal to Y and rearrange these letters, we get this famous equation that we call savings equals investment; that is, all the money we save in our economy goes to one of three uses. It either goes to finance bending spending as we lend it to businesses; it either goes to finance government budget deficit whenever we lend it to the government; or if we lend it to foreigners, we enable foreigners to run a trade surplus. They can buy more from us than we buy from them. Now, you can see from this equation where a trade surplus is likely to come from, or the flip side is a trade deficit. If this number is less than zero, that means we are importing more than we're exporting and we're running a trade deficit.
So where does a trade deficit come from? What is it that's going to cause this number to fall into the big negative digits? What's going to create a big negative trade surplus or a trade deficit for our economy? Well, it can come from one of three sources. First of all, suppose the government runs a big budget deficit. If the government spends a lot more than it takes in in taxes, where are we going to get that money? The government starts borrowing money to run a deficit, driving up interest rates in our domestic economy as the government hogs a bigger share of the savings. Well, what happens? Foreigners start lending us money to take advantage of those higher interest rates. The capital flows into our economy and that enables us to run a trade deficit. In fact, we can't run a trade deficit unless foreigners are lending us money. And foreigners can't lend us money without us running a trade deficit. So the trade deficit is the flip side of capital inflows. When foreigners are lending us money, they are doing so by allowing us to run a trade deficit. And that can happen if the government runs a big budget deficit. In fact, the government budge deficit and the trade deficit are twins. They happen together.
Well, what else could create a trade deficit? A trade deficit could occur if our economy is booming and businesses want to borrow a lot of money. They're going to drive up interest rates in our economy as everybody issues bonds to try to finance new factories and the acquisition of equipment. Well, the way businesses are going to get that finance is by foreigners lending us the money. As interest rates start to rise in our economy, foreigners lend us money to take advantage of the higher interest rates. Think about if as businesses importing the computers and equipment and tools that they need from abroad. That's where they get it whenever they have a sudden surge in demand for business expenditure.
And finally, it can happen if our domestic savings falls. If people in the United States decide that they don't want to save money, as has happened in recent months with the stock marketing booming and everybody wanting to spend this new-found wealth - people are spending more than they're making right now in income. And the way they're doing that is drawing down their savings and borrowing money. And they're borrowing from foreigners lending it to us, because people in the US aren't saving. The savings that makes the economy run right now is coming from foreigners that are buying stock and bonds in US companies.
So the trade deficit then is related to all of these other components of the macroeconomy. When the government runs a bigger budget deficit, when the demand for business spending is pumped up or when our domestic savings falls, any of these three developments is reflected in an increase in the trade deficit. If we're not saving in our economy or people want more savings than we've got, it's got to come from somewhere, and the most likely source is going to be foreigners.
Now, how can we adjust the trade deficit. Suppose we get concerned that the trade deficit is too big and we're borrowing too much money relative to what we can service in the long run. Well, here are some ways of adjusting the trade deficit. First of all, the government could run a smaller budget deficit. If the government runs a smaller budget deficit, then we don't need as much savings in our economy to meet the demand for business savings. Therefore, the trade surplus can increase and that is precisely what will happen. If we discouraged business spending, which would certainly be a bad thing for our economy, well, we probably would get a smaller trade deficit as well. And finally, if we encourage consumers in our economy to save a larger share of their income through tax advantages on 401K plans and individual retirement accounts, then that can be reflected, too, in needing to borrow less money from foreigners, which causes the trade deficit to shrink. Policy can also address the trade deficit directly. Imagine a policy where we impose tariffs and quotas on the imports of goods and services. This will discourage imports and therefore decrease them relative to exports, shrinking the trade deficit. This would show up with consequences elsewhere in the macroeconomy. Also, think about a policy in which the monetary authority, like the Federal Reserve, pumped a bunch more dollars in the world economy, causing the dollar to depreciate on world markets. When the dollar depreciates, that's going to discourage people in the United States from importing goods and services, because their prices will rise in US dollars, as it takes more dollars to buy a unit of foreign currency. Depreciation will also encourage foreigners to buy more of our goods, increasing exports, as it takes less foreign currency now to buy a US dollar and therefore get the products from our economy. So a depreciation of the dollar will lead to more exports and fewer imports, therefore the trade deficit will shrink as a result of the depreciation of the dollar. Again, that shows up with consequences for the rest of the macroeconomy.
Think for a moment about the consequences of depreciation. If the dollar becomes less valuable, then, until our purchasing patterns change, we're going to end up spending more money for our imports and making less off of our exports. Now, of course, in time, we're going to respond to these changes in dollar prices by buying less of the foreign goods and foreigners will start buying more of our goods. But until that happens, we're going to wind up spending more US dollars than before to get our imports and receiving less for our exports. In the short-run, our trade deficit is going to get worse when the dollar depreciates. We spend more dollars on imports, even though we're importing the same quantity of goods as before. This effect is called the J-curve, and let's see how it would look in a diagram.
On the vertical axis, I'm measuring our trade surplus. So when that number gets smaller, we've got a trade deficit. Whenever the number gets bigger, we're running a bigger surplus. And here's time being measured on the horizontal axis. And let me put one other benchmark in this picture; let's put zero, which represents balanced trade. So if we're below the zero line, we have a trade deficit and if we're above the zero line, we have a trade surplus. Consider what would happen then following a point in time, at which the Federal Reserve makes the dollar very plentiful in world markets, which leads to depreciation of the dollar, the dollar loses value. What happens immediately is people are still going to be importing the same quantity of goods and services as before. They've got contracts with suppliers overseas, it takes them time to find substitutes, and therefore, in the short-run, there is relatively inelastic demand for imported goods. The same with foreigners; they're going to continue to buy the same quantity of our exports as before, even though the prices are changing, because of the depreciation of the dollar. What happens in the short-run is we're spending more on imports than before, because the dollar price has gone up since the depreciation. Foreigners then are spending the same on our exports and our trade deficit gets worse. In the short-run, the trade deficit gets worse; it's only after a certain period of time that people can begin to change their behavior. Once you see that imports are getting more expensive because of the depreciation of the dollar, you're going to stop buying imports and start buying domestically produced goods instead. On the other hand, foreigners see that our exported goods, after the depreciation, are much less expensive to them in terms of their local currency, so they start loading up on our exports. What starts to happen after this change in behavior is the trade deficit starts moving in the other direction. We import less, foreigners buy more of our exports, and our trade balance moves in the direction of surplus. Look what happens; we get a J-shaped curve. Before people can change their behavior, the depreciation of the dollar increases our expenditure on imports because of a change in prices. However, after behavior changes, we start buying less imported goods and foreigners start buying more of our exports, so that the trade balance improves. And eventually, we may go above the zero line and actually wind up with a trade surplus, where we started with a trade deficit. The J-curve effect says that, in the short-run, the trade deficit gets worse after a depreciation, because of people's need to pay more for their imports. But in the long run, the change in their behavior makes the trade deficit smaller.
So this is the situation then with the trade deficit. The trade deficit arises because we've created a situation in our economy where we need to borrow money from foreigners, either because of the government budget deficit, a boom in business spending, or the fact that our own local residents are saving less. We can address the situation through policy, policies that increase savings, reduce the government budget deficit or encourage businesses to borrow less. Or we can address the trade deficit directly either through policy, like tariffs and quotas that discourage imports, or through a depreciation of the dollar that, in time, will move us toward a trade surplus, even though, in the short-run, they make the trade deficit worse.
Is the trade deficit a bad thing? The answer is it depends on what you're spending the money on. If you're borrowing to invest in productive capacity, it's like borrowing on a student loan or borrowing to start a business. But if you're just borrowing to waste the money, like credit card debt for consumer goods, then you're setting up a situation where you're going to be in trouble. This is why many developing countries run trade deficits. They have an opportunity to invest in productive capacity and increase their common wealth in the long run. But good policy is one that avoids trade deficits when the money is merely being spent for consumption goods.
International Focus
Exports, Imports, and Accounting
Trade Balances Page [3 of 3]

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