Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.
How Are Trade Deficits Determined?
Trade deficits occur when we see a negative balance in international transactions accounts. International transaction accounts record amounts regarding all economic transactions between countries.
When calculating a trade deficit, multiple different categories of the international transaction account are taken into consideration.
The main categories to look into are goods, services, goods and services, and the current account.
When put together, these four categories will equal the sum of balances for the current and capital accounts, which is equivalent to net lending or borrowing.
In other words, this international transaction account will measure a country’s financial assets and liabilities.
This amount will then be weighed against purchases and other payments. If the number you are left with is negative, it is in a trade deficit.
Benefits of Trade Deficits
One of the most significant benefits of a trade deficit is that it offers the opportunity for a country to pull in more than it produces.
This can help a country to reduce the risk of shortages and keep its economy moving.
In most cases, a trade deficit will correct itself with time. They promote a floating exchange rate within the country’s economy.
A floating exchange rate means that the market will be based on supply and demand rather than a fixed exchange rate, which the government determines.
In response to the floating exchange rate regime, imports will become more expensive than locally produced goods and services.
This persuades consumers to spend more of their money on domestic alternatives to imported goods.
When a country’s domestic currency depreciates, it will also result in less expensive exports, encouraging competitive prices throughout foreign markets.
Drawbacks of Trade Deficits
If a trade deficit goes uncorrected for a long time, it can have severe consequences. One of the most detrimental of these is economic colonization.
This happens when members from outside countries swoop in to acquire capital in the nation experiencing a trade deficit. If this continues for too long, foreign investors will come to own most of a country’s assets.
Fixed exchange rates can heighten the risks associated with trade deficits. When a fixed exchange rate regime is in effect, it is impossible to devalue the domestic currency and pull itself out of the trade deficit.
This can also boost unemployment rates. To free itself from a trade deficit, a country’s currency will require flexibility so it can adjust and rebalance naturally.
Key takeaways
To sum it up, a trade deficit occurs when a country’s imports outweigh its exports.
This leads to an imbalance within the international trade account, reflecting a deficit. In most cases, a company experiencing a trade deficit will balance itself out naturally, so long as it is in a floating exchange rate regime.
However, if a trade deficit lasts too long, it can have long-lasting consequences for a country’s economy.
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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
