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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.

7 comments:

  1. "Net trade flows can only change if capital flows change."

    I am not sure what this means, Nick. There are various mechanisms in the capital account flows which can do the adjustments. In the simple case, consider private flows to be the same as the previous period and exports and imports improve so that trade is in surplus as against deficit earlier. The thing which adjusts may just be the official purchase of foreign currency.

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    1. Agreed, but that official purchase of currency would be a capital flow, wouldn't it?

      As always, things depends here on what sort of scenario we are envisaging. If the monetary authority is targeting an exchange rate and therefore provides the matching item for all other flows, then this is like saying that capital flows are infinitely elastic at that exchange rate. I don't think that is what Mankiew or Dorman had in mind, and my points are rather more interesting (to me at least - if probably less so to others) when the exchange rate is fully floating, particularly if capital flows are relatively inelastic. Although, technically the points should be valid either way.

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    2. Sure would be included but my point is capital account can't determine net trade flows, although can affect it. I gave that example in which the adjustment happened via official flows instead. So private flows could have been the same in two different situations with different balance.

      So trade balance depends on relative competitiveness - both price and non-price - and also domestic demand and output at home and abroad. I could build an iPhone killer and completely change India's trade balance. Capital flows will respond to this and exchange rate might affect some things but not sure how that fits into "Net trade flows can only change if capital flows change."

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    3. But "Net trade flows can only change if capital flows change" must be correct because it's an identity, right? (Subject to the net interest income point.)

      I wouldn't go so far as to say that the trade balance is determined by capital flows. I think you have to look at everything - trade, savings levels and portfolio preference - and then work out how it resolves itself. But, I do think that you can't understand how we get persistent trade deficits without thinking about what is driving the capital flows that facilitate them.

      I'm not suggesting that changes in trade performance will have no impact on the trade balance. Simply that the extent to which they impact on the trade balance, as opposed to other things (primarily the exchange rate) depends on what factors are driving capital flows.

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  2. A lot of imports involve the import being exchanged with the importer's domestic currency, where that is the case, it is not a capital inflow, is it.

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    1. A trade item implies the creation of a financial asset between an agent in one country and an agent in the other (or possibly the transfer or destruction of an asset instead). That asset may be denominated in the currency of either country (or even possibly in a third party currency). This matters, because in involves at least one agent taking a position in what is to them a foreign currency and we need to ask what induces them to do so. This is, in my opinion, a very important point, but either way it is a capital flow.

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