What’s is: A trade deficit occurs when the value of a country’s exports is less than its imports. To finance the deficit, the country has to borrow from foreigners or sell assets (through investment inflows in the capital market, for example). This term is also known as a negative trade balance.
The opposite of a trade deficit is a trade surplus, where the value of exports exceeds the value of imports.
Trade deficit formula
The trade balance, or net exports, is the difference between export value and import value. If exports are higher than the value of imports, then a country experiences a trade surplus. Conversely, if imports are higher than the value of exports, they will experience a trade deficit.
Trade balance = Value of exports – Value of imports
The trade balance is part of the balance of payments at the current account section. Therefore, when there is a deficit, the current account will also decrease.
In the expenditure approach, the trade balance is also a component in calculating gross domestic product (GDP). The export value represents the demand from the foreign sector for domestic goods and services. Therefore, the export value has a positive relationship to GDP. I mean, the higher the export value, the greater the GDP value.
On the other hand, the import value represents domestic demand that is fulfilled from abroad. Because GDP only considers the value of goods and services produced domestically, an increase in import value will reduce GDP’s value. Conversely, a decrease in imports increases the gross domestic product.
The following is the GDP equation using the expenditure approach:
GDP = Consumption + Investment + Government spending + (Exports – Imports)
Factors affecting the trade deficit
Various factors affect a country’s trade balance. I will discuss six of them:
- Volume and price of the exported-imported goods and services
- Real income
- Exchange rate
- Economic growth
- Investment spending
- Structural factors
Volume and price
Since the trade balance is measured at nominal value, volume and price affect its value. It is similar to a firm’s revenue, where it is a function of quantity and price. If the export volume increases but the price falls, the effect on the value of the export depends on which one is more significant. That also applies to import values.
Prices are usually related to the comparative advantage of domestic products relative to foreign products.
When the real income of domestic consumers increases, this leads to more consumption. Since some goods are not produced domestically, this leads to a rise in import demand, especially goods and services with high demand elasticity.
Conversely, when foreign consumers’ income increases, we would expect the demand for domestic products also to increase. That will lead to higher exports.
And in macroeconomics, you can use economic growth to indicate whether a country’s income is increasing or not. When the domestic economy grows high, we expect consumers to be more prosperous and have a higher income level.
In general, a stronger currency can lead to a more significant trade deficit. How big the effect is on exports and imports depends on the price elasticity of the exported-imported products’ demand.
When a country’s currency exchange rate weakens (depreciates), domestic goods are cheaper for overseas consumers. It should increase the demand for domestic goods and services. Hence, we would expect the export value to be higher.
How high is the increase in exports? As I said earlier, it depends on the elasticity of export products. When it is elastic, the demand will tend to be high. Foreign consumers are relatively sensitive to price changes. Hence, a lower price due to exchange rate depreciation leads them to demand more highly.
On the other hand, the weakened domestic exchange rate makes imported goods more expensive for domestic consumers. It makes them reduce import demand. Again, the significance of the impact depends on the elasticity of the imported goods.
Well, let’s sum up the effect of exchange rates on the trade balance.
- Depreciation makes the price of domestic goods cheaper for overseas consumers. And foreign goods are more expensive for domestic consumers. Exports should go up, and imports should fall. The trade balance should be a surplus, ceteris paribus.
- Appreciation makes the price of domestic goods more expensive for overseas consumers. And foreign products are cheaper for domestic consumers. Exports should go down, and imports should go up. The trade balance should be in deficit (reduced), ceteris paribus.
Developing countries like Indonesia rely heavily on some capital goods and technology from abroad. They usually run into large trade deficits because they import capital equipment and components they cannot produce on their own. Therefore, when business capital expenditures increase, it increases the value of imports.
Investment spending is essential to increase the productive capacity of the economy. That will shift the long-run aggregate supply curve to the right, pushing up potential GDP.
And, in general, the trade deficit pressures resulting from the increase in imports of capital goods may be harmful in the short term. But, in the long run, it should be positive for the trade balance. I mean, since productive capacity increases, it should encourage increased exports in the long run.
If an economy is in the boom phase, usually the size of the trade deficit will increase as spending on imports increases.
Conversely, during the economic crisis, the trade deficit tends to improve. It is mainly due to the sharp decline in employment and real consumer incomes. The decline has led to cuts in consumer spending and demand for imported goods.
Subsequently, a global recession emerged, the demand for domestic goods fell due to the weakening economy in partner countries. Lower export demand tends to increase the trade deficit.
Structural factors refer to long-term changes in economic structure and supply-side competitiveness. I will present three of them:
- Research and development. Many countries innovate by advancing research and development. The aim is to create new products that are more competitive in the international market.
- Labor and capital productivity. High productivity leads to lower unit costs. That should lead to better export competitiveness.
- Industrial relocation. Some industries, such as textiles and steel, have moved to lower-cost countries or regions. It, of course, reduces domestic production and exports.
Trade deficit impacts
Trade deficits are not always bad. Often, it will fix itself over time. How can?
The trade deficit will depreciate the exchange rate. Say, a deficit occurred in Indonesia, and the rupiah exchange rate against the US dollar depreciated. The trade deficit means that there is less US dollar of export proceeds than is needed to pay for imports. Therefore, the demand for the US dollar increases, and its value against the rupiah will appreciate. For Indonesian, this means that the rupiah depreciates against the US dollar.
The depreciation of the domestic currency makes the prices of domestic goods cheaper for foreigners. That should encourage higher demand by overseas consumers. Then, exports increase.
Conversely, depreciation makes imported goods more expensive. As a result, import demand will tend to decrease.
As a result, the deficit gradually decrease. In economics, the relationship between the trade balance and the exchange rate is best illustrated by the J-Curve.
The increase in imports is also useful in terms of the variety of goods. Imports increase the entry of various goods and services available to domestic consumers.
High-growth economies tend to import more. The demand for imported goods is increasing because not all consumer needs are met domestically. Therefore, a trade deficit can also be a signal of strong economic growth.
Trade deficit effect on inflation
As I mentioned earlier, a trade deficit will depreciate the domestic currency.
Depreciation makes imported goods cheaper. If imported goods are consumer products, then domestic consumers will enjoy lower prices.
If imported goods are raw materials or capital goods, producers will enjoy lower production costs. Lower costs mean higher profits, even if they do not increase the selling price.
As a result, they alleviated the pressure on domestic inflation. Specifically, inflation caused by changes in the price of imported goods is called imported inflation.
Consequently, the trade deficit causes depreciation, which in turn, minimizes pressure from imported inflation.
The opposite condition applies when the trade balance is a surplus.
Long-term effects of the trade deficit
In the long run, a trade deficit can lead to fewer jobs. If the country imports more goods from foreign firms, prices will fall, and domestic firms cannot compete with low-cost, low-priced imported products.
Manufacturing firms are typically hardest hit when imports flood the domestic market. Perhaps, many of them have gone out of business because they cannot compete with imported products. Because domestic demand is mostly met from abroad, domestic production is reduced. That, in turn, results in reduced employment.
Low employment means more people are unemployed. In this condition, it is difficult for you to find a new job. And overall, the labor market faces excess supply.
The excess supply pushes the price of labor (wage) down. That, in turn, generates less income for the household. They will tend to reduce the consumption of goods and services, weakening aggregate demand. As a result, economic growth will tend to be depressed.
That is why, in economics, imports (leakage) represent a leak in the economy. Higher imports reduce domestic economic activities and income of economic actors.
What to read next
- International Trade: Why It Matters, Advantages, Disadvantages
- Reasons Why International Trade Exists
- What are the Benefits of International Trade?
- Import: Types, Influencing Factors, Impacts
- Exports: Importance, Types, Influencing Factors
- Trade Balance: Formula, Calculation, Impacts, and Affecting Factors
- Trade Surplus: How to Calculate, Affecting Factors, Pros, Cons
- Trade Deficit: Formula, Causes, Impacts
- Terms of Trade: Meaning, How to Calculate, Impacts
- Trade Sanction: Meaning, Reasons, Types, Pros, Cons
- Trade Restriction: Reasons, Types, and Impacts