# Trade and the Balance of Payments Deficit by mikeholy

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National Income Accounting

To understand the broad implications of international trades and capital flow on the
economy and manage them, we need to develop an accounting framework.

Our framework is built on the following accounting identity or relationship. Unlike a
standard economic model, it does not provide causality (if x then y) information. Rather,
the accounting framework describes relationships (when x then we also have y).

Accounting Identity

Output = Income

This relationship is based on the circular flow of economic activities (production
and consumption)

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Note that for domestic analysis, we focus on GDP which is equal to aggregate domestic
production income (or payments to factors of production).

GDP measures the market value of all final goods and services produced within
the country during a specified time period.

To understand the implications of international trade and capital flow, we focus on GNP
which is equal to ALL production income.

GNP is the value of all final goods and services produced by the labor, capital
and other resources of a country, regardless of where production occurred.

Within the context of GNP framework, which economy would you credit (record) for the
following production income?

Ford cars produced and sold in Europe

Insurance services supplied by AIG in Japan

Toyotas made and sold in US

Shell gasoline processed and sold in US

What is the relationship between GDP and GNP?

GNP = GDP +

Foreign investment income (return) received – Foreign investment income
(return) paid + Net unilateral transfers (e.g. direct foreign aid)

Note that net investment (itself) is not included in GNP. Only their income
generated is included.

We know domestically:

Domestic Output = GDP = Domestic Income (Expenditure)

And, GDP is equal to:

C + I + G + (X-M)

Where C is private consumption, I is private investment or business consumption,
G is government spending or consumption, X is export and M is import.

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Given the previous GDP formulation, X or export is positive for GDP. Whereas, I
or import is negative for GDP (via substitution effects).

Therefore, GNP is equal to:

C + I + G + (X-M) + Net foreign investment income + Net transfers

The balance of trade (or net exports, sometimes symbolized as NX) is the difference
between the monetary value of exports and imports in an economy over a certain period
of time. A positive balance of trade is known as a trade surplus and consists of
exporting more than is imported; a negative balance of trade is known as a trade deficit
or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a

What is the current level of trade deficit/surplus?

Go to http://www.bea.gov and check under International Economics Accounts
Data – Trade in Goods and Services.

What may be the potential effects of trade deficit on the US economy?

Before we focused on our current trade deficit issues with China, we were
focusing on Japan in the 80s. View http://www.youtube.com/watch?v=_qRQf-
WFXOE

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What is our current trade balance with China? Search the US Census data at

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Current Account Balance

The current account is the sum of the balance of trade (exports minus imports of goods
and services), net factor incomes (such as interest and dividends) and net transfer
payments (such as foreign aid). http://en.wikipedia.org/wiki/Current_account

GNP = C + I + G + (X-M) + Net foreign investment income + Net transfers

Current Accounts

The U.S. CA balance deteriorated rapidly since 1980. In fact, the U.S. CA balance was
in deficit by \$435.4 billion in 2000. This is mostly due to the large deficit in merchandize

What is the current US CA balance? Examine
http://www.economist.com/markets/indicators/

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What are the implications?

What happens when an economy persistently run a deficit in its CA balance each year?
To answer this question, we need to rearrange our accounting framework.

GNP = C + I + G + CA

Revision by accounting identify substitutions

GNP = C + S + T

S = I or savings is equal to investment. This relationship is based on a simple
assumption that to invest, you need to save.

G = T or government expenditure is equal to taxes. The level of government
spending is determined by its tax revenue.

CA is assumed to be = 0 to simplify the framework.

Since GNP = GNP (self identity), we have C + I + G + CA = C + S + T

Subtracting C from both sides and rearranging the terms:

I + G + CA = S + T

The previous accounting relationship of I + G + CA = S + T can be algebraically
rearranged as:

S + (T – G) = I + CA

Private Savings

Public Savings

S + (T – G) = I + CA

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This accounting relationship or identity indicates that:

Total Savings (private + public) = Investment + CA Balance.

It says that savings are required for investment (domestically) and a CA surplus.

What are the implications of CA deficits?

Net savings is negative.

Note that the US personal savings rate – percent seasonally adjusted annual rate has been
steadily declining during the past years:
http://research.stlouisfed.org/fred/data/gdp/psavert

Examine the US National Debt estimate at http://www.brillig.com/debt_clock/

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Given the following identify,

S + (T – G)     =        I     +       CA

-10                      +5            -15

Negative savings and current account deficits imply that domestic investment is only
possible by realizing higher levels of current account deficits.

What does this mean?

For now, foreigners are accumulating the dollars and in turn, they invest. If they invest in
US securities then this will only aggravate the current account deficit.

We have to pay for interests.

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Foreigners can also utilize the dollars to purchase US physical assets. This will be like us
going to a pawnshop to pay for excess consumption.

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Can CA deficits continue indefinitely?

No! Eventually (theoretically), foreigners will no longer want to hold onto the dollar or
own everything (e.g. run out things to pawn).

What will happen when foreigners stop buying US securities?

First, interest rates will increase if the US wants to continue to borrow to finance its
deficit spending. Higher interest rates will hurt the economy.

Second, if foreigners no longer need the USD, they will sell the USD. This will erode (or
depreciate) the value of the USD:

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The depreciating dollar will lead to either:

Increasing exports improve the CA balance. This will help to restore savings/investment
(from more income) and stimulate the economic growth.

However in the long run, increasing import prices and help usher in inflation. This will
increase long term interest rates and therefore, depressing economic growth.

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Do you think foreigners will sell the USD?

Do pray that foreigner investors do not sell out at once! This leads to capital flight and
financial crisis. The following economies were run over by the stampede - Herd
Behavior.

When will the dam break?

The empirical data suggest that when CA deficit gets to be more than 5 percent of GDP,
then the economy is at risk of a deep corrective recession.

Review Ferund (Federal Reserve) 2000 Study:
http://www.federalreserve.gov/pubs/ifdp/2000/692/ifdp692.pdf

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What happens if a high savings rate is maintained?

According to the referenced accounting relationship, Investment should be higher and/or
CA should be in surplus.

S + (T – G)    =      I      +       CA

+10            =

Perhaps, this is the key to improving the standard of living in the long run since
investment improves productivity in the long run.

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