The balance of trade

Trade deficits

The achievement of an overall balance of payments with the rest of the world is a key macroeconomic policy objective for a national economy.

Although trade flows (including trade in goods and services) are only one element of an economy's balance of payments, trade flows of imports and exports are considered to be most significant element.

The balance of payments also includes other components of the current account, such as earnings from investments, as well as the capital account.

A trade deficit means that the total value of trade in goods and services exported is less than the value imported over a period of time.

Trade deficits are an economic problem because:

1. They may indicate an over-heated economy
2. They may indicate low productivity and poor supply-side performance
3. The exchange rate may suffer as traders sell currency, creating inflationary pressure
4. The policy to correct a deficit may itself create problems
5. If other components of the current account do not compensate (such as investment income) a country's assets may need to be sold, or liabilities increased - (i.e. government borrowing)

Causes of a trade deficit

Trade deficits can occur for several reasons, including:

1. Excessive GDP growth - as an economy grows imports increase relative to exports
2. Poor export performance as a result of inferior quality or marketing
3. Import penetration over time as a result of 'de-industrialisation'
4. An over-valued currency, which deters exports and encourages imports
5. Ineffective micro and macroeconomic policy, including weak monetary control leading to domestic inflation
6. Barriers to trade imposed on exports

As noted, one consequence of rapid economic growth is that consumption rises, including the consumption of imports.  The cross diagram can help explain this.

Imports are a positive function of income [M = fY], with ‘f’ the marginal propensity to import (or MPM, for short).  So, as income rises, imports rise with it.

The assumption is that exports are a function of overseas’ GDP, hence the export line has a zero gradient.

As GDP increases (from Y to Y1), imports rise (from a to b), opening up a deficit of b to c. The greater the MPM, (at M1) the larger the trade deficit (c to d) as a result of growth.

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