Let's simplify the trade deficit to understand how it affects the economy, the country, and your life.
In 2016, the United States's trade deficit was at about $500 billion, but this figure doesn't mean much without an understanding of trade deficit.
A trade deficit occurs when a country imports more goods and services than it exports. In the event of a trade deficit, a country owes more to other nations than it is owed for exports. This leads to an outflow of domestic currency into foreign markets to cover the cost of the imported goods and services.
Calculating Trade: The Balance of Payment Ledger
Countries track and calculate total value of imports and exports using a balance of payment (BOP) ledger, similar to an account ledger used to record payments flowing in and out of a checking account to monitor the balance. The BOP ledger records all of the goods and services leaving the country (exports) and entering the country (imports), asset income (from foreign investments), direct transfers (foreign aid, for example), and net income (income received by residents). Together, the BOP ledger's columns calculate the equation for trade deficit which equals the total value of imports minus the total value of exports. If a negative figure, the bottom line of the BOP ledger, indicates a trade deficit, meaning we owe more than we are owed. A positive balance indicates a trade surplus.
A Make-Believe World, For Example
Imagine a country made entirely of ice, Chilltopia. Ice is its main export. Let's pretend this country has everything it needs to keep its citizens clothed, sheltered, fed, and happy – except the tools it needs to cut blocks of ice. As a result, Chilltopia must import tools from other countries to sustain its ice-based economy of exports. If, in one year, Chilltopia exports $1 million worth of ice cubes, but has to import $1.5 million in ice cutting tools, then the country will be left with a trade deficit of $500 thousand. This means they owe $500 thousand to the countries from which they imported tools to sustain their economy.
Is Trade Deficit Good or Bad?
The short answer is both. Trade deficits have the potential to provide resources for a country when the country cannot produce enough to meet its citizens' demands. Whether the demand is high due to abundant wealth or due to a lack of resources often indicates whether or not the trade deficit is healthy. if used responsibly, trade deficits can help a nation prosper, they can indicate a healthy economy, and they can lead to an exceptional variety of goods and services available to a nation's citizens.
A trade deficit introduces foreign goods and services into a previously closed market. The new competition drives down local prices, limiting inflation. This is healthy for an economy, to a point. If the low price of goods and services becomes so severe it drives locals out of business, then a trade deficit can harm a local economy. If businesses close, citizens lose jobs, income, and their buying power. Trade deficit and excessive imports become especially harmful to an economy when it effects local manufacturing jobs. The loss of local manufacturers means less competition for imports and less market stability.
When used responsibly, trade deficit has the power to provide consumers with an incredible variety of goods and services to enrich and enhance their daily lives.