The “trade balance” is a term that appears often in everyday news about the economy and in politics. It refers to the amount of trade that a country conducts, and it can be in surplus, in deficit, or balanced.

The trade balance is an important macroeconomic variable: countries that trade can increase their overall welfare by consuming at a point greater than their production possibilities frontier in autarky would suggest, by making use of comparative advantages in production. Or in other words, they earn more by exporting (some of) their produce that they are relatively efficient in producing, and trading it for goods they are less efficient at producing themselves.

However, trade imbalances can also pose problems for a country, such as increasing the amount of debt held by the domestic government, or making the domestic economy vulnerable to security issues or market fluctuations in other nations.

Defining the trade balance
The trade balance is a straightforward concept. It’s defined by the difference between exports (X) and imports (M). Exports are goods (or services) that are sold by domestic producers to foreign consumers, who pay into the domestic economy for them. Imports are foreign-produced goods and services that domestic agents purchase, sending their money abroad. 

The trade balance itself can be defined as NX, “net exports”, a term that appears in the equations for aggregate demand and certain approaches to calculating GDP. 

It should be clear to see that NX is negative when a country imports more than the country exports, which, according to the aforementioned equations, decreases economic output Y. This is because when imports are greater than exports, foreign consumers put less money into the domestic economy (to buy domestic goods) than domestic agents send outside of the domestic economy (to buy foreign goods).

In other words, the economy shrinks because money is leaving it. This situation is known as a trade deficit.

Conversely, if exports X are greater than imports M, NX is positive, and economic output Y is able to grow more than it would without trade. That’s because in this case, foreign investments add extra money to the domestic economy, allowing more economy-boosting savings and investment than would otherwise be possible. This situation is known as a trade surplus.

^{Image Credit: Tom Fisk / Pexels / Canva}

How trade balance is related to economic growth

Trade balance affects an economy’s capital accumulation, which is an important variable for economic growth (for example, see the Cobb-Douglas Production Function). When more capital is accumulated, the economy grows more (although this also increases the effects of depreciation and increases potential maintenance costs).

When X > M there is a trade surplus, which causes a “net capital inflow”. When M < X there is a trade deficit, which causes a “net capital outflow”. In other words, a trade surplus allows an economy to accumulate capital faster than it would be able to otherwise (and vice versa for a trade deficit).

Savings and the trade balance

According to the savings-investment identity, savings and investment are two sides of the same economic coin. Savings fuels investment, which grows the economy. Funds entering the economy via foreign agents can be seen as additional savings entering the equation from an outside source. In the case of an open economy with NX ≠ 0, investment equals total savings by domestic and foreign agents.

The equation for investment in an open economy is as follows: I = S = SD + (X – M), where I is investment, S is savings, SD is savings by domestic agents, and X – M represents net exports, which can be thought of as savings by foreign agents. When X – M is positive, there are more foreign savings flowing into the economy than domestic savings leaving it. When it is negative, domestic agents are sending more money abroad than foreigners are sending into the economy.

Again consider the case of a trade surplus X > M. It’s clear from the discussion of savings and trade balances that this will cause S to rise. This means that I rises too; therefore investment is increased by a trade surplus. This conclusion is reversed in the opposite case where X < M, so investment is lowered by a trade deficit.

Are trade imbalances good or bad?

Surpluses and deficits affect more than just savings and investment. A trade surplus can actually reduce unemployment, as domestic industries expand to meet the demand for exports. Additionally, a trade surplus can result in a stronger currency, making imports cheaper for domestic consumers.

However, while a trade surplus is often seen as a positive economic indicator, it can also indicate that a country is not consuming as much as it should domestically, suggesting an underutilization of resources. And, there are tradeoffs to consider, even from running a surplus. Export industries may actually suffer from a stronger domestic currency. That’s because a strengthening currency due to a trade surplus causes exports to be more expensive for consumers abroad, and therefore less competitive.

A trade deficit arises when a country's imports exceed its exports, and notoriously may lead to an increase in the national debt. This can lead to a loss of domestic jobs and an increase in unemployment, as imported goods may be cheaper than locally produced ones.

However, a trade deficit isn’t always bad, just like a surplus isn’t always good. A trade deficit can provide consumers with a wider variety of goods and services at lower prices, which in turn can help to keep inflation levels under control. And, exposing domestic industries to a higher degree of competition from foreign firms can force the former to become more efficient or innovative to survive. Further, a deficit can be the result of foreign entities clamoring to compete or invest in domestic markets, a sign that the domestic economy is seen as a strong investment.

Fiscal and monetary policy implications for the trade balance

The trade balance is closely interconnected with fiscal policy and monetary policy. Expansionary fiscal policies (for example, cutting taxes) can stimulate domestic demand. But, increased demand can lead to higher imports, as consumers and firms leverage their increased wealth to buy foreign goods! This can increase the trade deficit. Conversely, contractionary fiscal policies may help to reduce imports and narrow the trade deficit, but come at a cost of dampening the domestic economy.

Monetary policy, which mainly involves managing interest rates and the money supply, can also influence the trade balance. For example, a higher interest rate may attract foreign investors looking to save their money, which can lead to a strengthening of the domestic currency. This can increase the trade deficit by making domestic exports more expensive, and therefore less competitive, in foreign markets.

Overall, the trade balance is an incredibly interconnected macroeconomic variable that has wide-ranging implications across the economy. It can be difficult to determine if the trade balance itself is responsible for a changing economic situation, or if the myriad other related variables are culpable. The truth is that the economy is a complex and multifaceted entity. In some cases, economists may debate on whether a given surplus or deficit is good or bad for the current situation.

Good to Know

In the real world, the trade balance is a commonly debated topic among politicians, and it can be an important facet of international relations – for good or ill. Countries frequently engage in trade negotiations to address trade imbalances and promote fair competition, and free trade treaties are often heralded as major accomplishments.

^{Image Credit: Thomas K / Pexels / Canva}

For instance, Canada, Mexico and the United States signed the North American Free Trade Agreement in 1992, taking effect in 1994. This reduced the barriers to trade (such as eliminating tariffs) among the three major North American nations, and led to a slight increase in trade among them.

But, U.S. President Donald Trump – who rather (in)famously took an aggressive “America First” stance on trade issues – threatened to withdraw from NAFTA during his first term in office, complaining that it wasn’t beneficial enough for the US. Eventually, the agreement was replaced by the USMCA agreement under his administration, which includes additional provisions designed to help US industries compete more favorably against Canadian and Mexican competitors.