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Role of International Trade

Role of International Trade

Author: Kate Eskra

Identify the role of international trade in an economy.

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on the role of international trade. As always, my key terms are in red, and my examples are in green.

In this tutorial, we'll define and explain the balance of payments, which is comprised of both the current and capital accounts. We'll talk about the impact that trade deficits have on both of these accounts. And finally, you'll understand how international trade affects economic growth.

So after the Great Depression happened, economists realized they needed a better way to keep track of the United States economy. We know it's normal to go through fluctuations of growth and contraction, but they really wanted a better way to try to predict when a major depression was coming and to measure economic growth over time.

So the answer was to calculate GDP, or gross domestic product. You're certainly used to seeing this at this point. The idea here is that they developed national income accounting, which calculates GDP. And it's an attempt to measure all economic activity in a country in a year.

So in order to look at overall economic activity, we can either consider all output in an economy or all income in the economy. There's two aspects to it. Let's look at output first.

So when we find output, it's y equals c plus i plus g plus x. What that means is when things are produced, what happens to the output? Well it can either be consumed, invested, purchased by the government, or exported to other nations.

Now let's consider the other aspect, income. So when income is earned, what can be done with it? Well it can either be consumed, saved, paid in taxes, or paid to other nations for imports. That's where we get the m here. So if we compare these two, we know that obviously consumption is consumption.

We've already talked about how savings and investment are the same in the economy. When would g equal t? Well g would equal t when the government collects exactly in taxes what they spend. So when they're neither running a surplus nor budget deficit. If that's the case, that would mean that x would have to equal m. And that means that exports would equal imports. No trade deficit or trade surplus.

But x does not usually equal m. So what's going on here? Typically, we run a budget, I'm sorry, a trade deficit. So we're importing more than we're exporting with m greater than x. That is called a trade deficit. And in a couple of slides, I'll show you that also means a current account deficit.

So if that's the case, that means if we're looking at this on top of one another like this, that means that either investment is greater than savings, government expenditures are greater than taxes they're collecting, or a combination of both of them.

So let's remind ourselves what deficits are. A deficit is shortages that result from spending in excess of revenue. So one way to measure the economic impact of international trade-- which this tutorial is all about-- is to measure the balance of payments, which involves comparing our demand and supply of foreign exchange. So our balance of payments here is defined as a record of all monetary transactions that flow across a country's border. And two major components of it are the current account and the capital account. So I'm going to go through each of those.

So the current account represents the sum of all recorded transactions, including traded goods, services, income, and net transfer payments. So it's really the sum of our balance of trade. It shows how much a nation has spent on foreign goods, services, income, and transfer payments compared to how much it's earned on all of those things.

So as we already saw, a trade deficit means that we're running a current account deficit because we are spending more money for these things, for items that we're trading, we're spending more money on them than we are receiving. So we're importing more than we're exporting.

However, every transaction in the current account is going to be offset by a recorded transaction in the capital account. So the capital account is sometimes a little bit more complicated for people to understand. This is capturing investment and financing flows, not the actual physical flow of goods and services.

So inflows here are going to have an appreciating impact on a given currency. Outflows will have the opposite, or depreciating, impact. So this is comparing a nation's ownership of foreign assets and foreign ownership of that nations assets. So just as an example, the purchase or construction of machinery, buildings, and plants in other nations, investment in foreign nation shares and bonds, stuff like that.

So when foreigners invest in our country, that means we run a surplus in our capital account. When our citizens invest in foreign nations, it means we're running a deficit in our capital account.

So let's go back to this issue of a trade deficit. When our imports are greater than our exports, remember we talked about how this is a current account deficit. But what this means is now more United States currency is being used to purchase items from foreigners than other currencies are being used to purchase our goods. So this excess currency has to be used. And it will be used by foreigners to invest in our country, both in private investments and in public US Treasury securities.

This results, not in a deficit in an account, but in a surplus in our capital account. So here's just a nice, little chart I made as a summary discussing what I already said. When there's a trade deficit, our current account is running a deficit because we've spent more than we've made on goods and services. But in the capital account, it means we're running a surplus because foreigners are investing in our capital and securities with that extra US currency that they're making from over here.

Basically the end idea is that the current and capital account are going to sum to 0. If this were a trade surplus, it would just be the opposite situation. In a trade surplus, you're running a surplus in the current account but a deficit in the capital account.

So let's now talk about what impact this is going to have on our currency. So a current account deficit, or trade deficit, will cause a nation's currency to depreciate or get weaker over time. Think about it. If we're running a trade deficit, that means that our nation's currency is being supplied a whole lot to purchase these things from other nations. So that weakens our currency. Once our currency is weaker, Americans don't want to buy foreign products as much. So the imports start to decrease.

As soon as our currency is weaker, foreigners now, it's more attractive for them to purchase our goods. So then our exports would tend to increase. What's the end result? Basically, the current account deficit just tended to disappear because of the impact on our currency.

Now let's finish out talking about the impact of international trade on economic growth. So a big idea of macroeconomics is that when two countries trade, both nations are better off and are able to achieve greater economic growth. And this is due to comparative advantage and gains from trade.

So trading with other nations allows the country to focus on those goods and services for which they enjoy a comparative advantage due to their own particular resources or their workforce skill level or education.

The country then can trade for other goods and services for which other nations enjoy the comparative advantage in producing. If you want an actual example with a lot of details and numbers, there are other tutorials that have this in it by the way. Both countries, when they specialize in what they enjoy a comparative advantage in and trade, then both countries are better off than before.

And because international trade can increase productive efficiency this way, it can actually increase the rate of economic growth. So that's good. But keep in mind, we've also talked about how trade deficits and fiscal deficits cause a need to borrow money. And when nations borrow money, it leads to foreign purchases of Treasury bonds.

That interest that's then paid to foreigners has to be subtracted from GDP. So whereas we saw, yes, it can contribute to economic growth. Here in this aspect, that interest that has to be paid to foreigners can have a negative impact.

And just as a general note, any interest paid to Americans really doesn't tend to impact GDP that much. It can affect income equality or inequality, et cetera. But it doesn't really tend to have that much of an impact on GDP.

So in this tutorial, we looked at the balance of payments and the idea of the current and capital account. We saw what happens to the current and capital account when a nation runs a trade deficit. And finally, we had a discussion here of how international trade can impact economic growth.

Thanks so much for listening. Have a great day.

Terms to Know
Balance of Payments

A record of all monetary transactions that flow across a country’s border; two major components are the current account and the capital account.

Capital Account

Captures investment and financing flows; inflows have an appreciating impact on a given currency; outflows have the opposite, or depreciating, impact.

Current Account

Represents the sum of all recorded transactions including traded goods, services, income, and net transfer payments.


Shortages that result from spending in excess of revenue.