Monday, 5 December 2016

Trade Measures and the Capital Account

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.