After the Great Depression, economists realized they needed a better way to keep track of the United States economy. Even though it is normal to go through fluctuations of growth and contraction, they wanted a better way to predict when a major depression was coming and to measure economic growth over time.
The answer was to calculate GDP, or gross domestic product, a term you should be quite familiar with at this point. Thus, they developed national income accounting.
So, to look at overall economic activity, we can consider two aspects:
When we find output, we use the following equation. This is because when things are produced, the output can wither by consumed, invested, purchased by the government, or exported to other nations.
Well, it can either be consumed, saved, paid in taxes, or paid to other nations for imports.
So, if we compare these two, we know that clearly, consumption is consumption, and we have already covered how savings and investment are the same in the economy.
However, when would G equal T? Well, G would equal T when the government collects exactly in taxes what they spend. This means they are neither running a surplus nor budget deficit.
In this case, it means that X would have to equal M, that exports would equal imports, with no trade deficit or trade surplus.
This is called a trade deficit or current account deficit (which we will cover shortly). A deficit refers to shortages that result from spending in excess of revenue.
It this is the case, then, it means one of the following:
One way to measure the economic impact of international trade is to measure the balance of payments, which involves comparing our demand and supply of foreign exchange.
Balance of payments is defined as a record of all monetary transactions that flow across a country's border, and its two major components are the current account and the capital account.
It shows how much a nation has spent on foreign goods, services, income, and transfer payments compared to how much it has earned on all of those things.
So we previously saw, a trade deficit means that we are running a current account deficit because we are spending more money on these items that we are trading than we are receiving. We are importing more than we are exporting.
Inflows in the capital account have an appreciating impact on a given currency, while outflows have the opposite, or depreciating, impact.
This compares a nation's ownership of foreign assets and foreign ownership of that nation's assets.
EXAMPLEExamples would include the purchase or construction of machinery, buildings, and plants in other nations, or investment in foreign nation shares and bonds.
Circling back to the issue of a trade deficit, when our imports are greater than our exports, you may recall that this is a current account deficit.
However, 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 U.S. goods.
This excess currency has to be used, and it will be used by foreigners to invest in the U.S., both in private investments and in public U.S. Treasury securities.
This results in a capital account surplus, summarized in this chart:
|Current Account||Capital Account|
|U.S. has spent more than they have made on good and services, so they have a DEFICIT in the current account.||Foreigners are investing in U.S. capital/securities with extra U.S. currency from the trade situation, so the U.S. has a SURPLUS in the capital account.|
A current account deficit, or trade deficit, will cause a nation's currency to depreciate or get weaker over time.
If we are running a trade deficit, this means that our nation's currency is being supplied to purchase these things from other nations, which weakens our currency. Once our currency is weaker, Americans do not want to buy foreign products as much, so the imports decrease.
Now, as soon as our currency is weaker, foreigners will want to purchase more U.S. goods and exports increase. The end result is that the current account deficit tends to disappear because of the impact on our currency.
Let's wrap up today's lesson by discussing the impact of international trade on economic growth.
Trading with other nations allows a country to focus on those goods and services for which they enjoy a comparative advantage due to their own particular resources, 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. (Note, other tutorials cover actual examples in greater detail).
When both countries specialize in what they enjoy a comparative advantage in, and trade, they are both better off than before.
Because international trade can increase production efficiency, it can actually increase the rate of economic growth--which is a good thing.
However, keep in mind, we have also learned that trade deficits and fiscal deficits cause a need to borrow money, and when nations borrow money, it leads to foreign purchases of Treasury bonds.
The interest from those bonds is then paid to foreigners and must be subtracted from GDP.
Therefore, while international trade can contribute to economic growth, in this aspect, the interest paid to foreigners can have a negative impact.
Source: Adapted from Sophia instructor Kate Eskra.