Peter Dorman comments on Mankiew's NYT piece on the trade
deficit. This concerns the extent to
which the balance of trade depends on capital flows and what this implies when thinking
about the consequences for output and employment.
There are a couple of points worth emphasising here:
1. Measures aimed at improving trade performance will have
no impact on the trade balance if capital account flows remain unchanged (also
assuming investment income is unchanged).
2. Such measures do not actually need to change the trade
balance in order to be effective.
The first point is simply an accounting statement, but it helps
highlight some important mechanics.
Net trade flows can only change if capital flows
change. So in order to understand how
net trade will respond to trade measures, we have to also understand how
capital flows will respond. The miracle
of accounting ensures that every piece of trade will be matched by a financial
flow. But it is not only the item of
trade that has to acceptable to the agents involved. The change in balance sheets also has to be
acceptable.
If it is not, something has to give. This is probably the exchange rate and in the
extreme case this would stop the trade item happening by making it no longer
attractive.
Now, measures taken to improve trade performance may have
consequences which impact on the preferences agents have for financial
balances. The most obvious possibility
here is again movements in the exchange rate.
But, in the extreme case, where financial preferences do not respond,
there can be no change in the trade balance.
However, this does not mean that trade measures can have no
effect unless they change balance sheet preferences. This brings us to the second point. The easiest way to show this is to start with
some simple identities. We have net
exports (NX) as exports (X) less imports (M):
NX = X -M
and we define the import propensity (m) as imports divided
by GDP (Y)
m = M / Y
An elementary re-arrangement gives:
Y = ( X - NX ) / m
This shows that, if our concern is the impact on output and
employment, then trade measures can be
effective without needing to change the trade balance. If the trade balance is in fact driven by
inelastic flows on the capital account, measures that increase exports or
reduce the import propensity can still raise output.
