International Trade and Capital Flows

Introduction to the International Trade and Capital Flows

Figure 10.1 A World of Money We are all part of the global financial system, which includes many different currencies. 

The balance of trade (or trade balance) is any gap between a nation's dollar value of its exports, or what its producers sell abroad, and a nation's dollar value of imports, or the foreign-made products and services that households and businesses purchase. Recall from The Macroeconomic Perspective that if exports exceed imports, the economy has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports and imports are equal, then the trade is balanced, but what happens when trade is out of balance and large trade surpluses or deficits exist?

Germany, for example, has had substantial trade surpluses in recent decades, in which exports have greatly exceeded imports. According to the World Bank, in 2020, Germany ran a trade surplus of $242 billion. In contrast, the U.S. economy in recent decades has experienced large trade deficits, in which imports have considerably exceeded exports. In 2020, for example, U.S. imports exceeded exports by $651 billion.

A series of financial crises triggered by unbalanced trade can lead economies into deep recessions. These crises begin with large trade deficits. At some point, foreign investors become pessimistic about the economy and move their money to other countries. The economy then drops into deep recession, with real GDP often falling up to 10% or more in a single year. This happened to Mexico in 1995 when their GDP fell 8.1%.

Several countries in East Asia – Thailand, South Korea, Malaysia, and Indonesia – succumbed to the same economic illness in 1997–1998 (called the Asian Financial Crisis). In the late 1990s and into the early 2000s, Russia and Argentina had identical experiences. What are the connections between imbalances of trade in goods and services and the flows of international financial capital that set off these economic avalanches?

We will start by examining the balance of trade in more detail by looking at some patterns of trade balances in the United States and around the world. Then, we will examine the intimate connection between international flows of goods and services and international flows of financial capital, which, to economists, are really just two sides of the same coin. People often assume that trade surpluses like those in Germany must be a positive sign for an economy, while trade deficits like those in the United States must be harmful. As it turns out, both trade surpluses and deficits can be either good or bad. We will see why in this chapter.

Source: Rice University, https://openstax.org/books/principles-macroeconomics-3e/pages/10-introduction-to-the-international-trade-and-capital-flows
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Measuring Trade Balances

A few decades ago, it was common to track the solid or physical items that planes, trains, and trucks transported between countries as a way of measuring the balance of trade. Economists call this measurement the merchandise trade balance. In most high-income economies, including the United States, goods comprise less than half of a country's total production, while services comprise more than half.

The last two decades have seen a surge in international trade in services, powered by technological advances in telecommunications and computers that have made it possible to export or import customer services, finance, law, advertising, management consulting, software, construction engineering, and product design. Most global trade still takes the form of goods rather than services, and the government announces, and the media prominently reports the merchandise trade balance. Old habits are hard to break. Economists, however, typically rely on broader measures such as the balance of trade or the current account balance, which includes other international flows of income and foreign aid.

Components of the U.S. Current Account Balance

Table 10.1 breaks down the four main components of the U.S. current account balance for the last quarter of 2015 (seasonally adjusted). The first line shows the merchandise trade balance, that is, exports and imports of goods. Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade deficit. We can explain how the government collects this trade information in the following Clear It Up feature.

Table 10.1 Components of the U.S. Current Account Balance for 2020 (in billions of dollars).

The second row of Table 10.1 provides data on trade-in services. Here, the U.S. economy is running a surplus. Although the level of trade in services is still relatively small compared to trade in goods, the importance of services has expanded substantially over the last few decades. For example, U.S. exports of services were equal to about one-half of U.S. exports of goods in 2020, compared to one-fifth in 1980.

The third component of the current account balance, labeled "income payments," refers to money that U.S. financial investors received on their foreign investments (money flowing into the United States) and payments to foreign investors who had invested their funds here (money flowing out of the United States). The reason for including this money on foreign investment in the overall measure of trade, along with goods and services, is that, from an economic perspective, income is just as much an economic transaction as car, wheat, or oil shipments: it is just trade that is happening in the financial capital market.

The final category of the current account balance is unilateral transfers, which are payments that governments, private charities, or individuals make in which they send money abroad without receiving any direct good or service. Economic or military assistance from the U.S. government to other countries fits into this category, as does spending abroad by charities to address poverty or social inequalities. When an individual in the United States sends money overseas, as is the case with some immigrants, it is also counted in this category.

The current account balance treats these unilateral payments like imports because they also involve a stream of payments leaving the country. For the U.S. economy, unilateral transfers are almost always negative. This pattern, however, does not always hold. In 1991, for example, when the United States led an international coalition against Saddam Hussein's Iraq in the Gulf War, many other nations agreed that they would make payments to the United States to offset the U.S. war expenses. These payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive $10 billion.

The following Work It Out feature steps you through the process of using the values for goods, services, and income payments to calculate the merchandise balance and the current account balance.