Balance of Trade

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Balance of Trade?

The balance of trade (BOT) is defined as the difference between the value of exports and the value of imports of a country. The figure that is derived shows how economically stable a nation is. It is one of the significant components of any economy’s current asset as it measures a country’s net income earned on global investments.

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For eg:
Source: Balance of Trade (wallstreetmojo.com)

The existing account also takes into consideration all payments across country borders. Essentially, the trade balance is easy to measure as all goods and services pass through the customs office and are thus recorded.

Key Takeaways

  • Balance of trade refers to the difference in value between the country’s imports and exports of goods and services over time.
  • A trade surplus or deficit is not always an economy’s health final indicator. One must consider it along with the business cycle and other economic indicators.
  • A trade deficit is a more favorable trade balance depending on the country’s business cycle stage.
  • Some countries are opposed to trading deficits. They adopt mercantilism to control them.

Balance of Trade Explained

The balance of trade is one of the significant components for any economy’s current assetCurrent AssetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more as it measures a country’s net income earned on global investments.

An economy with a trade surplus lends money to deficit countries, whereas an economy with a large trade deficit borrows money to pay for its goods and services. In addition, in some cases, the trade balance may correlate to a country’s political and economic stability, reflecting the amount of foreign investment. Therefore, most nations view this as a favorable trade balance.

When exports are less than imports, it is known as a trade deficit. Countries usually regard this as an unfavorable trade balance. However, there are instances when a surplus or favorable trade balance is not in the country’s best interests. For a balance of trade examples, an emerging market, in general, should import to invest in its infrastructureInfrastructureInfrastructure refers to fundamental physical and technological frameworks that a region or industry establishes for its economy to function properly.read more.

Common debitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more items include foreign aid Foreign AidForeign aid or international aid refers to the voluntary transfer of resources like money, goods like food, drugs, weapons, or technical services, and training from a developed country to a developing one in the form of a loan. Governments or international or non-governmental organizations provide it to address issues like terrorism, environmental degradation, pandemics, etc.read more, imports, domestic spending abroad, and domestic investments abroad. In contrast, credit items include foreign spending in the domestic economy, exports, and foreign investmentForeign InvestmentForeign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.read more in the domestic economy.

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Types

As briefly stated above, there are two types of balance of trade – favorable/positive trade balance or trade surplus, and unfavorable/negative trade balance or trade deficit.

Favorable/Positive Trade Balance

The balance of trade is positive and favorable when an economy’s exports are more than its imports. Most countries work to create policies that encourage a trade surplus in the long term. They consider surplus a favorable trade balance because it makes a country profit. In addition, nations prefer to sell more products when compared to buying products that receive more capital for their residents, which translates into a higher standard of living. It is also beneficial for their companies to gain a competitive advantageCompetitive AdvantageCompetitive advantage refers to an advantage availed by a company that has remained successful in outdoing its competitors belonging to the same industry by designing and implementing effective strategies that allow the same in offering quality goods or services, quoting reasonable prices to its customers, maximizing the wealth of its stakeholders and so on and as a result of which the company can make more profits, build a positive brand reputation, make more sales, maximize return on assets, etc.read more in expertise by producing exports. That results in more employment as companies employ more workers and generate more income.

But in certain conditions, a trade deficit is a more favorable balance of trade, depending on the stage of the business cycle Business CycleThe business cycle refers to the alternating phases of economic growth and decline.read more the country is currently in.

  • Another balance of trade example is Canada, whose small trade deficit results from economic growth. As a result, its residents enjoy a better lifestyle afforded only by diverse imports.

Unfavorable/ NegativeTrade Balance

This is the situation that arises when a country imports more than it exports. Also termed as trade deficitsTrade DeficitsWhen the total sum of goods or services that a country imports from other countries is higher than the total sum of goods or services that a country exports to other countries, this is referred to as a trade deficit, which is the opposite of the balance of trade theory.read more, such situations lead to an unfavorable trade balance for a country. As a criterion, geographies with trade deficits export only raw materials and import many consumer products. Domestic businesses of such countries do not gain experience with the time needed to make value-added products in the long run as they are the main raw material exporter. Thus, the economies of such countries become dependent on global commodity prices.

Some countries are so opposed to trading deficits that they adopt mercantilismMercantilismMercantilism refers to an economic policy or trade system wherein a country focuses on maintaining a favorable trade balance by maximizing exports and minimizing imports with other countries. Its purpose is to empower a nation via wealth and resource acquisition while improving its military and political might. read more to control them. That is considered an extreme form of economic nationalism that removes the trade deficit in every situation.

It advocates protectionist measures such as import quotasImport QuotasImport quotas are a type of government-imposed restriction on the trading of a certain commodity. Such restrictions are either fixed in terms of the value or quantity of the product to be imported during a given time period (usually for one year). The government imposes such restrictions in order to benefit local producers.read more and tariffsTariffsA tariff is levied by a government on the import of goods or services from another country. The charges increase government revenue, restrict trade with other countries, and protect domestic manufacturers from stiff competition.read more. Although these measures may reduce the deficit in the short runShort RunA Short Run in economics refers to a manufacturing planning period in which a business tries to meet the market demand by keeping one or more production inputs fixed while changing others.read more, they raise consumer prices. Along with this, such actions trigger reactionary protectionism from other trade partners.

Formula

The balance of trade formula is as follows:

Balance of Trade = Country’s Exports – Country’s Imports.

For example, suppose the USA imported $1.8 trillion in 2016 but exported $1.2 trillion to other countries. Then, the USA had a trade balance of -$600 billion, or a $600 billion trade deficit.

$1.8 trillion in imports – $1.2 trillion in exports = $600 billion trade deficit

Examples

Let us consider the example to see how to calculate the balance of trade figures:

The US has had a trade deficit since 1976, whereas China has had a trade surplus since 1995.

Balance of Trade - China

source: tradingeconomics.com

A trade surplus or deficit is not always a final indicator of an economy’s health. It must be considered along with the business cycle and other economic indicators Economic Indicators Some economic indicators are GDP, Exchange Rate Stability, Risk Premiums, Crude Oil Prices, etc. read more. For example, for the balance of trade examples in economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more, countries prefer to import more to promote price competition, limiting inflation. Conversely, in a recession, governments export more to create economic jobs and demand.

Importance

To understand the balance of trade definition more clearly, it is important to know how it enables analysts to learn if an economy is advancing towards growth and progress. Here are a few points to show how it proves to be helpful:

  • The balance of trade and the balance of payment are interrelated as the former helps in calculating the latter. The difference between the balance of trade and the balance of payment is that the first one is the difference between a country’s exports and imports figures, while another derives the figure to show how much a country owes to another country and how much is owed to it,
  • To maintain the balance of trade, countries dive into international trade, which boosts the foreign trade sector, and leads to the development of better trade policies.
  • It plays a great role in maintaining the Gross Domestic Product (GDP) of a country.
  • It encourages foreign exchange reserves as international trade gets a significant boost.

Frequently Asked Questions (FAQs)

What is the difference between balance of trade and balance of payment?

Balance of trade refers to the difference between the country’s imports and exports. At the same time, the balance of payment is the difference between the inflow and outflow of the foreign exchange.

What are the types of balance of trade?

The three types of balance of trade are a favorable balance trade, an unfavorable/deficit balance of trade, and an equilibrium balance of trade.
The components of the balance of trade are exports and imports of goods and services.

What is a surplus balance of trade?

A surplus balance of trade is referred to as a country’s exports exceeding the imports of goods and services.

What are the factors affecting the balance of trade?

The factors affecting the country’s balance of trade are factor endowments, productivity, trade policy, exchange rates, foreign currency reserves, inflation, and demand.

This article is a Guide to what is Balance of Trade. Here we explain the concept with a formula with examples, types, and importance. You may learn more about macroeconomics from the following articles: –

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Comments

  1. Generosa Eloise Yankey says

    It is very helpful

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