Tag: Financial account

Supports: Macroeconomics, Chapter 18, and Economics, Chapter 28.

In an article on axios.com, economic journalist Neil Irwin discussed the Bureau of Economic Analysis’s latest data on gross domestic product. He noted: (1) “In the arithmetic around U.S. economic output, trade acted as a more severe drag [in 2021] than it has in a generation.” and (2) “The flip side of higher trade deficits is higher debt. In the third quarter [of 2021], net U.S. borrowing from abroad was $127 billion as the current account deficit widened 8.3%.”

1. What does Irwin mean that during 2021 international trade acted as a “severe drag” on real GDP? What’s a severe drag? What must have been true of the relationship between U.S. imports and exports during 2021 for international trade to have been a severe drag on U.S. real GDP?
2. Why is the flip side of high trade deficits higher debt? What is the link between U.S. borrowing from abroad and the current account deficit?

Solving the Problem

Step 1:  Review the chapter material. This problem is about the effect of a trade deficit on real GDP and on U.S. borrowing abroad, so you may want to review Macroeconomics, Chapter 8, Section 8.1, “Gross Domestic Product Measures Total Production,” and Chapter 18, Section 18.4, “The International Sector and National Saving and Investment.”

Step 2: Answer part 1. by explaining what the phrase “severe drag” means and indicate what must have been true of the relationship between imports and exports in order for international trade to have been a severe drag on U.S. real GDP. By severe drag, Irwin means that real GDP would have significantly higher if not for the effects of international trade. We know that increases in U.S. real exports—holding all other factors constant—increase U.S. real GDP and increases in U.S. real imports reduce U.S. real GDP. If international trade was a severe drag on U.S. real GDP in 2021, then imports must have been significantly larger than exports—that is, net exports must have a large negative number. In fact, net exports were −$1.28 trillion, which was the largest gap ever between real exports and real imports.

Step 3: Answer part 2. by explaining why a trade deficit leads to larger U.S. borrowing from abroad. A trade deficit occurs when the U.S. imports more goods and services than it exports. The current account balance is determined mainly by the trade balance, so if the United States is running a trade deficit it will typically also run a current account deficit. The financial account balance roughly equals net capital flows, which equal net foreign investment with the opposite sign. 

Therefore, as we show in Macroeconomics, Section 18.4:

Current account balance + Financial account balance = 0

or:

Current account balance = −Financial account balance

or:

Net exports = Net foreign investment

When net exports are negative, so is net foreign investment. In other words, a trade deficit results in the United States borrowing from abroad. So, Irwin is correct to write that the “flip side of higher trade deficits is higher debt.”

Source:  Neil Irwin, “Covid Created an Epic U.S. Trade Gap,” axios.com, January 27, 2022.