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Trade Deficit: Working, Causes and Effects

  • Vrinda Mathur
  • Apr 06, 2022
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When a country's imports surpass its exports in a fiscal year, the country is said to be running a trade deficit. The trade deficit is also known as the negative trade balance.


Introduction to Trade Deficit


A trade deficit happens when a country's imports outnumber its exports over a specific time period. It is also known as a negative trade balance (BOT).


The balance can be determined for various types of transactions, including products (sometimes known as "merchandise"), services, and goods and services. Balances for international transactions (current account, capital account, and financial account) are also computed.


A trade deficit happens when an international transaction account has a negative net amount or balance. The balance of payments (international transaction accounts) documents all economic transactions involving residents and non-residents that result in a change in ownership.


Within an international transaction account, a trade deficit or net amount can be determined in many categories. These are goods, services, goods and services, current account, and the sum of current and capital account balances.


The total of the current and capital account balances equals net lending/borrowing. This also equals the financial account balance plus a statistical mismatch. In contrast to the current and capital accounts, which measure purchases and payments, the financial account measures financial assets and liabilities.


Goods and services, as well as primary and secondary income payments, are all included in the current account. Payments (financial investment returns) from direct investment (more than 10% ownership of a business), portfolio investment (financial markets), and other sources constitute primary income.


Government grants (foreign aid) and pension payments, as well as private remittances to households in other countries, are examples of secondary income payments (e.g., sending money to friends and relatives).


Exchanges of assets, such as insured disaster-related losses, debt cancellation, and transactions involving rights, such as mineral, trademark, or franchise, are all included in the capital account.


The current account and capital account balances determine an economy's exposure to the rest of the world, whereas the financial account (which tracks financial assets rather than products or revenue flows) explains how it is financed. 


In theory, the sum of the three accounts' balances should be zero, however there is a statistical disparity since the source data for the current and capital accounts differs from the source data for the financial account.


Trade deficits occur when a country lacks the efficient capacity to produce its own products, whether owing to a lack of talent and resources to develop that capacity or a preference to buy from another country (such as to specialize in its own goods, for lower cost or to acquire luxuries).


Also Read | Balance of Trade


Working of Trade Deficit


We need to understand the factors affecting the balance of trade:

Factors affecting working of Trade Deficit :- 1. Factor Input Cost 2. Taxation, Sanctions, Tariffs and  Quotas 3. The Quantity of Forex Available 4. Currency Exchange Rates 5. Economic Cycle

Factors affecting working of Trade Deficit 

  1. Factor Input Costs


Input factors such as raw materials, labor, land rents, taxes, and so on influence the cost of production of goods and services produced in the country. A rising cost of production makes the items less competitive in the international market, resulting in a decrease in exports. If nothing changes, the deficit will grow or the surplus will shrink.



  1. Currency Exchange Rates


In international trade, depreciation of a domestic currency is a positive since it boosts the purchasing power of foreign consumers because one unit of foreign currency can buy more units of foreign goods. As a result, exports increase, resulting in a decrease in the deficit or an increase in the surplus.



  1. Taxation, Sanctions, Tariffs, and Quotas


All of these policies restrict the flow of products between two countries, resulting in a deficit for the exporting country and a surplus for the importing country if they are applied. One rationale for such impositions is to stimulate the domestic economy.



  1. The Quantity of Forex Available


For importing countries, the quantity of Forex they have becomes significant since they cannot import products unless and until they can pay for them. At times, countries agree to make the transaction in their own currency rather than utilizing a third-party exchange currency such as the US dollar. 


Importing is easier in such instances because a country has more control over the amount of its own money in circulation. A few years ago, in 2018, India agreed to buy Iranian oil and pay for it in Indian National Rupees; later, the US imposed sanctions; nonetheless, such transactions are common.



  1. Economic Cycle


Exporting countries have a surplus or a contraction of the deficit during the economic boom or expansion phase, whereas importing countries have a deficit or a contraction of the surplus. During a recession, the opposite is true.


Also Read | Guide to Forex Trading


Benefits vs Drawbacks of Trade Deficit


A trade deficit is neither totally positive nor entirely detrimental. To begin with, a trade deficit is not always a bad thing. However, a trade deficit has long-term implications on the economy, including job offshoring and a weakening economy. 


Is it better to have a trade deficit or a trade surplus? Let's go over some of the trade deficit’s drawbacks and benefits




  1. Increases the Standard of Living


Trade deficits may raise people's living standards by making a variety of products available through imports that they would not be able to produce in the domestic market. 


A country can gain access to commodities and services at a very low cost. A country can import beneficial commodities and services in exchange for bits of paper, also known as money.


A country's trade deficit permits it to consume more than it generates. Furthermore, trade deficits can assist countries avoid shortages of products by allowing them to import them from other countries.


  1. Comparative Advantage


A country has a comparative advantage when it can manufacture a product or service at a cheaper cost than others. Country A, for example, focuses on vehicle manufacturing because it is less expensive. 


Country B, on the other hand, is dedicated to the development of mobile phones for the same reason. Trade specialization enables both countries to purchase more vehicles and cell phones. According to economic study, when countries trade with one another, global wealth increases and all countries benefit.


  1. Foreign Direct Investment


One of the advantages of a trade deficit is that it draws huge capital inflows, particularly in the form of foreign direct investment (FDI). Money that leaves the country to pay for imports comes back in to help pay for productive investment in new capital. Take the United States as an example.


In 2019, Americans purchased around $616 billion more goods and services from overseas than foreigners purchased from the United States. However, foreigners sent roughly that amount back to the United States to assist American enterprises in building infrastructure/factories, creating jobs, and increasing growth.


Also Read | What is Futures Trading?




  1. Dangerous to Developing Countries


Typically, a developing country works to expand its home market and industry while focusing on export rather than import. If the country imports more and more only to meet the demands of its citizens and maintain their level of life, the economy will deflate and the fiscal situation will deteriorate.


Domestic products must compete with imported products and must cut their prices. Because of the appeal of foreign items, even doing so will not help the home market thrive.


  1. Outsourcing of Jobs


When items are taken from other nations or imported instead of being sold in the home market, a trade deficit occurs. This forces domestic businesses or industries to contract, resulting in fewer domestic jobs. The decrease in the utilization of domestic commodities is the cause of the decline in job possibilities.


G.D.P. assesses the value of goods and services produced within a country's borders, therefore when a country sells less things outside than it buys from abroad, the country makes less stuff, and as a result, fewer jobs are created. 


In the near term, a trade deficit is not a terrible thing, but persistent deficits will have major consequences for domestic employment.


  1. Resulting in Foreign Ownership


When a country consistently runs trade deficits, residents from other countries accumulate funds to invest in that country. Though it attracts foreign investment, which boosts productivity and creates jobs, it also has certain negative consequences for the country. 


It may also entail just purchasing existing enterprises, natural resources, and other assets. If the current trend continues, foreign investors will possess practically everything in the country.


  1. Currency Value Depreciation


Trade deficits cause the currency's value to fall when compared to foreign currencies. This raises the price of imported items and contributes to inflation


Domestic currency flows to foreign markets as a result of the trade deficit, resulting in a decline in currency value in the global market.


When a country sells exports, it also converts foreign currency payments back into domestic currency, which strengthens the home currency. This strengthens the indigenous currency. 


To summarize, trade deficits may be expected to contribute to a weaker currency in the long run, as the economy adjusts to generate the surpluses required to repay foreign investors.


Causes and Effects of Trade Deficit 


  1. Causes


A trade imbalance happens when a country does not produce everything it requires and must borrow from other countries to pay for imports. This is referred to as a current account deficit. 


When corporations manufacture items in other countries, they incur a trade deficit. Raw materials for manufacturing that are shipped overseas for factory manufacture are considered an export. 


When fully manufactured goods are delivered back to the country, they are counted as imports. Even while the earnings may enhance the company's stock price and the taxes may increase the country's income stream, imports are deducted from the country's GDP.


  1. Effects


To begin with, a trade deficit is not always a bad thing. It can increase a country's level of life since inhabitants can access a broader range of goods and services at a lower cost.  It can also minimize the threat of inflation by lowering prices. 


A trade deficit might lead to increased employment outsourcing to other countries over time. When a country imports more items than it purchases locally, it may produce fewer jobs in particular industries. At the same time, international firms will almost certainly hire more employees to meet the increased demand for their exports.


Also Read | Types of Trade Barriers and their Effects 

A country that runs a trade imbalance spends more on imports than it earns on exports. In the short run, a negative trade balance reduces inflation. However, a large trade deficit undermines domestic industry and reduces job possibilities over time. 


A country's reliance on imports also makes it vulnerable to economic downturns. Currency depreciation, for example, raises the cost of imports. Inflation is boosted by this condition.


A trade deficit is not always harmful because it has the ability to self-correct over time. Importing more from other nations lowers the prices of consumer products produced inside the country's borders, which aids in the control of inflation in the local economy. 


While an increase in imports increases the number of opportunities for citizens of a country to interact with variety. A rapidly expanding economy may import more as a result of continual expansion, which increases demand. 


As a result, a trade deficit indicates that the economy is expanding at a steady pace.

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