A Critical Analysis of the Impact of Trade Balance on Economic Growth

Imagine that a country’s trade balance is in deficit. According to economists, deficits can be detrimental as any nation which spends more on imports than exports is not winning at trade.

Studies conducted across several time periods and data sources have confirmed the negative impact of trade balance ratio changes on economic growth. Results can differ depending on factors like period, data source and measurement methods for trade.

Economic Growth

The trade balance measures the monetary value of exports and imports over a specific time period for any country, as part of its broad current account which also encompasses international investment as well as some official (government) flows.

Deficits show that nations sold abroad less than they purchased abroad during a given period, yet that doesn’t indicate poor global commerce practices. Periods of robust economic expansion often coincide with large trade deficits as domestic consumers and businesses purchase more goods from abroad and foreign investors invest their money into domestic economies.

Reducing a trade deficit through increasing tariffs on imported goods will likely only serve to worsen it, according to CFR fellows Benn Steil and Emma Smith in this PBS NewsHour video. For maximum effectiveness in bringing down an excessive trade deficit, raising domestic savings rates through either cutting consumption or decreasing borrowing from abroad should be prioritized as the means.

Current Account Deficit

Current account deficit is an aggregate measure of net foreign liabilities in any country and several lines of empirical evidence suggest it cannot be sustained over the long run.

One approach is to assume that an increase in income, as indicated by economic development, leads to an increase in demand for imported goods and services from abroad. Since a nation’s marginal propensity to import is determined by income alone, import volumes will track these fluctuations closely.

The second approach involves looking at international capital markets. When functioning properly, foreign investors will continue to increase their holdings of U.S. assets even when domestic saving declines – thus shifting Figure 5.4’s investment S curve rightward and leading to sustainable deficits. Should policy change cause disruption of this system however, foreign investors would withdraw holdings of American assets and potentially make deficits unsustainable.

Current Account Surplus

A country experiences a current account surplus when its exports, income from international investments and current transfers (like foreign aid and remittances ) exceed imports. Such an imbalance can make a nation an ‘outright lender’ on the global financial stage and influence factors like economic growth, currency level and monetary policy.

An increase in trade surplus can also serve as a signal of an economically healthy and competitive economy, often leading to stronger domestic currencies; though this largely depends on the context in which it occurs.

An affordable currency can help make products more competitive in international markets and decrease dependency on foreign investment, potentially increasing export-led growth while decreasing dependence. On the other hand, if a country’s surplus results from under-investment in its domestic economy it could contribute to poverty, unemployment rates, inequality and slow social progress – this Chicago Fed Letter explores all these implications of having a trade surplus while discussing demand elasticity, international trade policies and global economic conditions as possible determining factors.

International Trade

As other regions offer better climate and terrain conditions for cultivating certain species, no single country can be self-sufficient in all commodities. To address this shortcoming, countries resort to international trade in order to sell what they produce domestically while also importing non-domestic goods and services that cannot be produced domestically. International trade can bring many economic advantages; including creating jobs within its borders, improving productivity and giving consumers greater purchasing power.

Researchers remain divided over the impact of trade balance on economic growth. This may be attributed to its empirical evidence being sensitive to factors like analysis period, data source and measurement units used.

This study investigates whether the impact of trade balance results (deficit or surplus) differ depending on its outcome (deficit or surplus). Multivariate regression analyses show that an increase of one percent in ratio of trade deficit reduces economic growth by 0.04 percentage points on average.