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31.3: The United States in the Global Economy

The Importance of Trade

International trade is an integral part of the modern world economy.

learning objectives

  • Discuss the reasons of the U.S. increase in international trade participation after World War II

 Economists generally support trade because it allows for increased overall utility for both countries. Gains from trade are commonly described as resulting from:

silkroutes.jpg 

Silk Road Trade: Even in ancient times, people benefited from widespread international trade. The benefits from international trade have increased as costs decline and the international system becomes better integrated.

  • specialization in production from division of labor (according to one’s comparative advantage), economies of scale, scope, and agglomeration and relative availability of factor resources in types of output by farms, businesses, location and economies
  • a resulting increase in total output possibilities
  • trade through markets from sale of one type of output for other, more highly valued goods.

 

The Rise of International Trade

International trade is important, and, over time, has become more important. There have been three primary reasons for this increase in importance.

First, there have been large reductions in the cost of transportation and communication. It is now much cheaper to not only operate internationally and trade with foreign partners, but also to exchange information between potential buys and sellers.

Second, technological advances have made international production and trade easier to coordinate. More efficient telecommunications, from the first transatlantic telephone cable in 1956 to the popularization of the internet in the 1980s and 1990s, have allowed companies to exchange goods more efficiently and lowered the costs of international integration. Technological advances, from the invention of the jet engine to the development of just-in-time manufacturing, have also contributed to the rise in international trade.

Third, trade barriers between countries have fallen and are likely to continue to fall. In particular, the Bretton Woods system of international monetary management has shaped the relationship between the world’s major industrial states and has resulted in a much more integrated system of international exchange. Established in 1946 to rebuild the international economic system after World War II, the Bretton Woods Conference set up regulations for production of their individual currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade.This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system. Although the world eventually abolished the system of fixed exchange rates, the goal of more open economies and free international trade remained.

 

The Balance of Trade

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period.

learning objectives

  • Explain the relationship between the trade balance of a nation and its economic well-being

The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period, measured in the currency of that economy. It is the relationship between a nation’s imports and exports. It is measured by finding the country’s net exports. A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.

Factors that can affect the balance of trade include:

  • The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting economy compared to those in the importing economy
  • The cost and availability of raw materials, intermediate goods, and other inputs
  • Currency exchange rate
  • Multilateral, bilateral, and unilateral taxes or restrictions on trade
  • Non-tariff barriers such as environmental, health, or safety standards
  • The availability of adequate foreign exchange with which to pay for imports
  • Prices of goods manufactured at home

In addition, the trade balance is likely to differ across the business cycle. In export-led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

Twin Deficits Hypothesis

The twin deficits hypothesis is a concept from macroeconomics that contends that there is a strong link between a national economy’s current account balance and its government budget balance. This link can be seen from considering the national accounting model of the economy:

\[Y=C+I+G+(NX)\]

\(Y\) represents national income or GDP, \(C\) is consumption, \(I\) is investment, \(G\) is government spending, and \(NX\) stands for net exports (exports minus imports). This represents GDP because all the production in an economy (the left hand side of the equation) is used as consumption (\(C\)), investment (\(I\)), or government spending (\(G\)), and the leftover production is exported (\(NX\)).

Another equation defining GDP using alternative terms (which in theory results in the same value) is:

\[Y=C+S+T\]

\(Y\) is again GDP, \(C\) is consumption, \(S\) is savings, and \(T\) is taxes. This is because national income is also equal to output, and all individual income either goes to pay for consumption (\(C\)), to pay taxes (\(T\)), or becomes savings (\(S\)).

Since \(Y=C+I+G+NX\), and \(Y−C−T=S\), then \(S=G−T+NX+I\), which simplifies to:

\[(S−I)+(T−G)=(NX)\]

If \((T−G)\) is negative, we have a budget deficit. Assuming that the economy is at potential output (meaning \(Y\) is fixed), if the budget deficit increases and savings and investment remain the same, then net exports must fall, causing a trade deficit. Thus, budget deficits and trade deficits go hand-in-hand.

twine.png 

Twin Deficits in the US: In the U.S., net borrowing has tended to have a direct relationship with net imports. The red line represents net imports, which is equivalent to the negative balance of trade, and the black line represents net borrowing, which is equivalent to the government budget deficit. Although the two are not identical, a rise in one tends to accompany a rise in the other, and vice versa.

The twin deficits hypothesis implies that as the budget deficit grows, net capital outflow from a country falls. This is because the nation is financing its spending by selling assets to foreigners. The total rate of national savings falls, which may lead to an increase in the interest rate as lending to the country (i.e. buying bonds and other financial assets) becomes more risky.

 

Key Points

  • The international market serves as an important place for the exchange of goods and services.
  • Economic theory shows that there are gains from trade for both countries involved.
  • Advances in transportation has dramatically reduced the costs of moving goods around the globe.
  • Technological advances have made international production and trade easier to coordinate.
  • Trade barriers between countries have fallen and are likely to continue to fall.
  • A positive balance is known as a trade surplus if it consists of exporting more than is imported; a negative balance is referred to as a trade deficit or, informally, a trade gap.
  • Factors that can affect the balance of trade include the currency exchange rate, cost of inputs, barriers to trade such as tariffs and regulations, and the prices of domestic goods.
  • The twin deficits hypothesis contends that there is a strong positive relationship between a national economy’s current account balance and its government budget balance.

Key Terms

  • comparative advantage: The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.
  • production possibilities curve: The various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production
  • net capital outflow: The net flow of funds being invested abroad by a country during a certain period of time.
  • net exports: The difference between the monetary value of exports and imports.

 

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