Trade Deficit

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Trade Deficit?

Trade deficit refers to a scenario where the total sum of goods and service imports is higher than a country’s exports. It is the surplus outflow of domestic currency in foreign markets. The inflow of foreign currency is much less.

It is considered a negative balance of trade. The balance of paymentsBalance Of PaymentsThe formula for Balance of Payment is a summation of the current account, the capital account, and the financial account balances. The term balance of payments refers to the recording of all payments and obligations pertaining to imports from foreign countries vis-à-vis all payments and obligations pertaining to exports to foreign countries. It is the accounting of all the financial inflows and outflows of a nation.read more (BOP) considers international receipts, international payments, and cross-border trade activities. International investments flow-through current accounts, capital accounts, and financial accounts.

Key Takeaways

  • A trade deficit is a scenario where a nation’s imports exceed exports. It represents a negative balance of trade—based on inflow and outflow volumes.
  • It occurs when the domestic production is lower than the nation’s consumption. Alternatively, deficits occur when local companies set up manufacturing units in foreign countries. This is usually done to avail cheap labor.
  • According to economic theory, consistent trade deficits have adverse effects on a nation’s economic outlook.
  • The US has more deficits than any other country. It is proving economic theories wrong—the dollar is still seen as the world’s reserve currency.

Trade Deficit Explained

Trade Deficit

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A trade deficit occurs when a country’s imports exceed exports. It measures the outflow of domestic currency into foreign markets. We can easily calculate a deficit by subtracting a country’s total exports from total imports—pertaining to a specific period.  

Whenever a nation is incapable of producing sufficient goods to fulfill domestic requirements, the need for import arises. Excessive imports also suggest that consumers have significant buying power.

Imports are not always detrimental to a nation’s economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more —they can correct themselves over time. Imported goods are the prices of domestically produced consumer goods–this way, the local economy keeps inflation in check. For the consumers, imports signify an abundance of choice. Sometimes, fast-growing economies import more due to expansion and increased demand.

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Formula and Calculation

The formula for computing the trade deficit of a nation is as follows:

Trade Deficit=Value of Imports-Value of Exports

Measuring a country’s net imports or net exportsNet ExportsNet exports of any country are measured by calculating the value of goods or services exported by the home country minus the value of the goods or services imported by the home country. It includes various goods and services exported and imported by the government, like machinery, cars, consumer goods.read more is quite tedious. Investment flows through various accounts—current accounts, capital accounts, and financial accounts.

  • Analysts consider all transactions related to the inflow (import) and outflow (export) of goods or services in the current account.
  • The capital account shows the inflow and outflow of investments and debt.
  • The financial account states the increase or decrease in the foreign ownership of domestic assets and domestic ownership of foreign assets.

A trade surplus or trade deficit is not always sufficient for studying a country’s trade balance. We need a final indicator to further study the economy’s health during a business cycleBusiness CycleThe business cycle refers to the alternating phases of economic growth and decline.read more.

Trade Deficit Examples

In January 2022, the US trade deficit amounted to $89.7 billion—higher than the forecasted figure of $87.1 billion. Imports amounted to $314.1 billion—this included natural gas, crude oil, capital goodsCapital GoodsCapital goods are man-made assets used in the manufacturing process of a product. They are used to produce the final goods that people consume daily. They are one of the four factors of production- the other three being natural resources, labor, and entrepreneurship.read more, copper, food products, and passenger cars.

Following is the change in the US deficit between 2021 and 2022:

(source)

Also, almost one-third of the total deficit, i.e., $355.3 billion, accounted for the goods imported from China. Historical data show the US having deficits since 1976. Meanwhile. China had a trade surplus in 1995.

Causes

Some of the reasons that trigger deficits are discussed below:

Effects

Nobel Prize-winning economist Milton Friedman stated trade deficits are not as harmful as they seem. The currency will always come back to a country in one form or another.

Given below are its various positive and negative impacts:

Frequently Asked Questions (FAQs)

How can the trade deficit be reduced?

The government and the federal reserve can take the following measures to reduce deficits:
– Measures to decrease consumption can be taken.
– The government can nudge citizens to save more.
– Governments can discourage borrowing from foreign countries by imposing taxes on capital inflows,
– Countries can increase import costs through exchange rate depreciation.

Which country has the largest trade deficit?

In 2020, the United States had the highest trade deficit—$97,591.

How does the trade deficit affect economic growth?

Generally, a nation with a negative trade balance keeps inflation under control due to low prices of goods or services. Further, it motivates domestic companies to produce competitive products against foreign companies. Thus, it aids in the country’s economic development.

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