Trade Deficit

and

Its Impacts and Elimination

Date              17/4/ 1996
Instructor       B. Hutchinson
Student          C. Tolunay

          Trade is the magic word for almost all the countries now. There are still some countries with closed economies, but many countries in the world are trading with each other. It seems the benefit of trade has been appreciated in today's world.

          As trading gains more popularity, trade deficit concept becomes an important issue. Nations pay their imports by exporting their goods. Trade deficit is pronounced when a nation's imports are more than its exports. In other words, the nation is buying more than  selling. Thus, although trade is very favorable,  at the same time trade deficit is fearsome.

          A nation starts trading process by importing the goods that it does not have or unable to produce domestically. To pay the cost of buying importing goods the nation starts selling the goods that it produces more efficiently. If the nation's exports exceeds the imports, it will have a surplus in balance of trade. Although this condition is very desired, it is not easy to maintain it. As the nation keeps the surplus, the foreign currency flow will increase the income level and wealth of nation will rise. As the income level increase, the demand for import goods will increase. Furthermore, in the exchange market, since the demand for nation's goods is higher, the exchange rate will decrease. In other words, demand for nation's currency will push its value higher compared to foreign currency. This will make the import goods cheaper for the nation and will increase the demand for imports even higher. At the same time, strong currency will hurt the exports as it makes the nation's goods more expensive for other countries. Then if the level of imports exceeds the exports, the nation will experience trade deficit.

          In Mack Ott's article, myth 1 believes that trade deficit indicates non competitiveness. As the theory says, increasing income level, increases the demand for imports. The strong currency causes a deficit also. In that sense, no matter how competitive the nation's goods are as surplus brings more foreign currency and causes an appreciation in the nation's currency, the nation's imports will increase and exports will decrease. In the end, it is normal to see the nation experience trade deficit.

          However, according to the theory trade deficit condition is temporary. As the nation has a trade deficit in balance of payments its high demand for imports will cause an increase in the exchange rate. Nation's shifted demand for foreign currencies will intersect the supply of foreign currencies at a higher exchange rate which means a depreciation in the nation's currency. This process works as a automatic adjustment system that fixes the trade deficit. Decline in the income level because of the capital outflow and depreciating currency will lower and eliminate the deficit problem.

          Another issue with the trade deficit is the large nation's deficit and its effect. By saying large nation we mean that the size of the economy of the nation is big enough to affect the rest of the world. Thus, any changes in the level of the large nation's  exports or imports will affect other countries.

            US  is a large country with its big size economy and population. As US imports goods from rest of the world (ROW), the income level in those countries increases. Since US exports is the function of the other countries income, its export level depends on the ROW's income. Thus, with this higher income level, ROW will import more goods from US.  In other words by buying ROW's goods and making them wealthier, US creates its demand and realizes an increase in its exports. This returning cycle is called feedback and will help US to minimize its trade deficit but it does not guaranty the elimination of it.

          A small nation has no impact on the ROW. Its size of the economy and trade is very small and insignificant in the international trade volume. Its small volume import level will make no change in ROW. Thus the income level of ROW will not change as the small nation's import or export level changes. As a result a small nation can experience no feedback effect.

          Another trade deficit myth says that American standard of living is on the verge of decline. This myth believes that because of the deficit in the balance of payments the life standard is decreasing. To this myth the trade deficit must be eliminated as soon as possible. However there is a very important point that been  ignored here. The US is operating at full employment level or at least it is very close to that point.  Thus, any devaluation attempt to eliminate the trade deficit would result with an undesired outcome. According to the theory, devaluation would decrease the importing and would increase the demand for US goods. As the aggregate demand increases to suppliers will try to produce more. But, since the economy is very close to full-employment level, it will not be able to increase the production to high demand level. Thus, the domestic prices for export products will increase. Then, with price  increase in imports, exports and import subsidy goods, the US will end up with inflation. Depreciation or devaluation can be effective only if domestic absorption falls.

          A depreciation or devaluation of the deficit nation’s currency automatically reduces domestic absorption if it redistributes income from wages to profits. Also, rising domestic prices push people into higher tax bracket and also reduce consumption. And now, this can reduce the American standard.

          Obviously there is always a balance in the actions. Trade deficit may look harmful and should be avoided, at the same time the opportunity cost must be considered  as well.