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245 Chapter 10 | The International Trade and Capital Flows

10 | The International Trade
and Capital Flows

Figure 10.1 A World of Money We are all part of the global financial system, which includes many different
currencies. (Credit: modification of work by epSos.de/Flickr Creative Commons)

More than Meets the Eye in the Congo

How much do you interact with the global financial system? Do you think not much? Think again. Suppose
you take out a student loan, or you deposit money into your bank account. You just affected domestic savings
and borrowing. Now say you are at the mall and two T-shirts “made in China,” and later contribute to a
charity that helps refugees. What is the impact? You affected how much money flows into and out of the United
States. If you open an IRA savings account and put money in an international mutual fund, you are involved in
the flow of money overseas. While your involvement may not seem as influential as that of someone like the
president, who can increase or decrease foreign aid and, thereby, have a huge impact on money flows in and
out of the country, you do interact with the global financial system on a daily basis.

The balance of payments—a term you will meet soon—seems like a huge topic, but once you learn the
specific components of trade and money, it all makes sense. Along the way, you may have to give up some
common misunderstandings about trade and answer some questions: If a country is running a trade deficit, is
that bad? Is a trade surplus good? For example, look at the Democratic Republic of the Congo (often referred
to as “Congo”), a large country in Central Africa. In 2013, it ran a trade surplus of $1 billion, so it must be doing
well, right? In contrast, the trade deficit in the United States was $508 billion in 2013. Do these figures suggest
that the United States economy is performing worse than the Congolese economy? Not necessarily. The U.S.
trade deficit tends to worsen as the economy strengthens. In contrast, high poverty rates in the Congo persist,
and these rates are not going down even with the positive trade balance. Clearly, it is more complicated than

246 Chapter 10 | The International Trade and Capital Flows

simply asserting that running a trade deficit is bad for the economy. You will learn more about these issues
and others in this chapter.

Introduction to International Trade and Capital Flows
In this chapter, you will learn about:

• Measuring Trade Balances

• Trade Balances in Historical and International Context

• Trade Balances and Flows of Financial Capital

• The National Saving and Investment Identity

• The Pros and Cons of Trade Deficits and Surpluses

• The Difference between Level of Trade and the Trade Balance

The balance of trade (or trade balance) is any gap between a nation’s dollar value of its exports, or what its producers
sell abroad, and a nation’s dollar value of imports, or the foreign-made products and services that households and
businesses purchase. Recall from The Macroeconomic Perspective that if exports exceed imports, the economy
has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports and imports are equal, then
trade is balanced, but what happens when trade is out of balance and large trade surpluses or deficits exist?

Germany, for example, has had substantial trade surpluses in recent decades, in which exports have greatly exceeded
imports. According to the Central Intelligence Agency’s The World Factbook, in 2016, Germany ran a trade surplus
of $295 billion. In contrast, the U.S. economy in recent decades has experienced large trade deficits, in which imports
have considerably exceeded exports. In 2016, for example, U.S. imports exceeded exports by $502 billion.

A series of financial crises triggered by unbalanced trade can lead economies into deep recessions. These crises begin
with large trade deficits. At some point, foreign investors become pessimistic about the economy and move their
money to other countries. The economy then drops into deep recession, with real GDP often falling up to 10% or
more in a single year. This happened to Mexico in 1995 when their GDP fell 8.1%. A number of countries in East
Asia—Thailand, South Korea, Malaysia, and Indonesia—succumbed to the same economic illness in 1997–1998
(called the Asian Financial Crisis). In the late 1990s and into the early 2000s, Russia and Argentina had the identical
experience. What are the connections between imbalances of trade in goods and services and the flows of international
financial capital that set off these economic avalanches?

We will start by examining the balance of trade in more detail, by looking at some patterns of trade balances in the
United States and around the world. Then we will examine the intimate connection between international flows of
goods and services and international flows of financial capital, which to economists are really just two sides of the
same coin. People often assume that trade surpluses like those in Germany must be a positive sign for an economy,
while trade deficits like those in the United States must be harmful. As it turns out, both trade surpluses and deficits
can be either good or bad. We will see why in this chapter.

10.1 | Measuring Trade Balances

By the end of this section, you will be able to:

• Explain merchandise trade balance, current account balance, and unilateral transfers

• Identify components of the U.S. current account balance

• Calculate the merchandise trade balance and current account balance using import and export data for

a country

A few decades ago, it was common to track the solid or physical items that planes, trains, and trucks transported
between countries as a way of measuring the balance of trade. Economists call this measurement is called the

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247 Chapter 10 | The International Trade and Capital Flows

merchandise trade balance. In most high-income economies, including the United States, goods comprise less than
half of a country’s total production, while services comprise more than half. The last two decades have seen a surge
in international trade in services, powered by technological advances in telecommunications and computers that have
made it possible to export or import customer services, finance, law, advertising, management consulting, software,
construction engineering, and product design. Most global trade still takes the form of goods rather than services, and
the government announces and the media prominently report the merchandise trade balance. Old habits are hard to
break. Economists, however, typically rely on broader measures such as the balance of trade or the current account
balance which includes other international flows of income and foreign aid.

Components of the U.S. Current Account Balance
Table 10.1 breaks down the four main components of the U.S. current account balance for the last quarter of 2015
(seasonally adjusted). The first line shows the merchandise trade balance; that is, exports and imports of goods.
Because imports exceed exports, the trade balance in the final column is negative, showing a merchandise trade
deficit. We can explain how the government collects this trade information in the following Clear It Up feature.

Value of Exports (money
flowing into the United States)

Value of Imports (money
flowing out of the United

States)
Balance

Goods $410.0 $595.5 –$185.3

Services $180.4 $122.3 $58.1

Income receipts

and payments

$203.0 $152.4 $50.6

Unilateral

transfers

$27.3 $64.4 –$37.1

Current

account

balance

$820.7 $934.4 –$113.7

Table 10.1 Components of the U.S. Current Account Balance for 2015 (in billions)

How does the U.S. government collect trade statistics?

Do not confuse the balance of trade (which tracks imports and exports), with the current account balance,
which includes not just exports and imports, but also income from investment and transfers.

The Bureau of Economic Analysis (BEA) within the U.S. Department of Commerce compiles statistics on the
balance of trade using a variety of different sources. Merchandise importers and exporters must file monthly
documents with the Census Bureau, which provides the basic data for tracking trade. To measure international
trade in services—which can happen over a telephone line or computer network without shipping any physical
goods—the BEA carries out a set of surveys. Another set of BEA surveys tracks investment flows, and there
are even specific surveys to collect travel information from U.S. residents visiting Canada and Mexico. For
measuring unilateral transfers, the BEA has access to official U.S. government spending on aid, and then also
carries out a survey of charitable organizations that make foreign donations.

The BEA then cross-checks this information on international flows of goods and capital against other available
data. For example, the Census Bureau also collects data from the shipping industry, which it can use to
check the data on trade in goods. All companies involved in international flows of capital—including banks

248 Chapter 10 | The International Trade and Capital Flows

and companies making financial investments like stocks—must file reports, which the U.S. Department of the
Treasury ultimately checks. The BEA also can cross check information on foreign trade by looking at data
collected by other countries on their foreign trade with the United States, and also at the data collected by
various international organizations. Take these data sources, stir carefully, and you have the U.S. balance of
trade statistics. Much of the statistics that we cite in this chapter come from these sources.

The second row of Table 10.1 provides data on trade in services. Here, the U.S. economy is running a surplus.
Although the level of trade in services is still relatively small compared to trade in goods, the importance of services
has expanded substantially over the last few decades. For example, U.S. exports of services were equal to about one-
half of U.S. exports of goods in 2015, compared to one-fifth in 1980.

The third component of the current account balance, labeled “income payments,” refers to money that U.S. financial
investors received on their foreign investments (money flowing into the United States) and payments to foreign
investors who had invested their funds here (money flowing out of the United States). The reason for including this
money on foreign investment in the overall measure of trade, along with goods and services, is that, from an economic
perspective, income is just as much an economic transaction as car, wheat, or oil shipments: it is just trade that is
happening in the financial capital market.

The final category of the current account balance is unilateral transfers, which are payments that government,
private charities, or individuals make in which they send money abroad without receiving any direct good or service.
Economic or military assistance from the U.S. government to other countries fits into this category, as does spending
abroad by charities to address poverty or social inequalities. When an individual in the United States sends money
overseas, as is the case with some immigrants, it is also counted in this category. The current account balance treats
these unilateral payments like imports, because they also involve a stream of payments leaving the country. For the
U.S. economy, unilateral transfers are almost always negative. This pattern, however, does not always hold. In 1991,
for example, when the United States led an international coalition against Saddam Hussein’s Iraq in the Gulf War,
many other nations agreed that they would make payments to the United States to offset the U.S. war expenses. These
payments were large enough that, in 1991, the overall U.S. balance on unilateral transfers was a positive $10 billion.

The following Work It Out feature steps you through the process of using the values for goods, services, and income
payments to calculate the merchandise balance and the current account balance.

Calculating the Merchandise Balance and the Current Account
Balance

Exports (in $ billions) Imports (in $ billions) Balance

Goods

Services

Income payments

Unilateral transfers

Current account balance

Table 10.2 Calculating Merchandise Balance and Current Account Balance

Use the information given below to fill in Table 10.2, and then calculate:

• The merchandise balance

• The current account balance

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249 Chapter 10 | The International Trade and Capital Flows

Known information:

• Unilateral transfers: $130

• Exports in goods: $1,046

• Exports in services: $509

• Imports in goods: $1,562

• Imports in services: $371

• Income received by U.S. investors on foreign stocks and bonds: $561

• Income received by foreign investors on U.S. assets: $472

Step 1. Focus on goods and services first. Enter the dollar amount of exports of both goods and services
under the Export column.

Step 2. Enter imports of goods and services under the Import column.

Step 3. Under the Export column and in the row for Income payments, enter the financial flows of money
coming back to the United States. U.S. investors are earning this income from abroad.

Step 4. Under the Import column and in the row for Income payments, enter the financial flows of money going
out of the United States to foreign investors. Foreign investors are earning this money on U.S. assets, like
stocks.

Step 5. Unilateral transfers are money flowing out of the United States in the form of, for example, military aid,
foreign aid, and global charities. Because the money leaves the country, enter it under Imports and in the final
column as well, as a negative.

Step 6. Calculate the trade balance by subtracting imports from exports in both goods and services. Enter this
in the final Balance column. This can be positive or negative.

Step 7. Subtract the income payments flowing out of the country (under Imports) from the money coming back
to the United States (under Exports) and enter this amount under the Balance column.

Step 8. Enter unilateral transfers as a negative amount under the Balance column.

Step 9. The merchandise trade balance is the difference between exports of goods and imports of goods—the
first number under Balance.

Step 10. Now sum up your columns for Exports, Imports, and Balance. The final balance number is the current
account balance.

The merchandise balance of trade is the difference between exports and imports. In this case, it is equal
to $1,046 – $1,562, a trade deficit of –$516 billion. The current account balance is –$419 billion. See the
completed Table 10.3.

Value of Exports (money
flowing into the United

States)

Value of Imports (money
flowing out of the United

States)
Balance

Goods $1,510.3 $2,272.9 –$762.6

Services $750.9 $488.7 $262.2

Income

receipts and

payments

$782.9 $600.5 $182.4

Unilateral

transfers

$128.6 $273.6 –$145.0

250 Chapter 10 | The International Trade and Capital Flows

Value of Exports (money
flowing into the United

States)

Value of Imports (money
flowing out of the United

States)
Balance

Current

account

balance

$3,172.7 $3,635.7 –$463.0

Table 10.3 Completed Merchandise Balance and Current Account Balance

10.2 | Trade Balances in Historical and International

Context

By the end of this section, you will be able to:

• Analyze graphs of the current account balance and the merchandise trade balance

• Identify patterns in U.S. trade surpluses and deficits

• Compare the U.S. trade surpluses and deficits to other countries’ trade surpluses and deficits

We present the history of the U.S. current account balance in recent decades in several different ways. Figure 10.2
(a) shows the current account balance and the merchandise trade balance in dollar terms. Figure 10.2 (b) shows the
current account balance and merchandise account balance yet again, this time as a share of the GDP for that year. By
dividing the trade deficit in each year by GDP in that year, Figure 10.2 (b) factors out both inflation and growth in
the real economy.

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251 Chapter 10 | The International Trade and Capital Flows

Figure 10.2 Current Account Balance and Merchandise Trade Balance, 1960–2015 (a) The current account
balance and the merchandise trade balance in billions of dollars from 1960 to 2015. If the lines are above zero
dollars, the United States was running a positive trade balance and current account balance. If the lines fall below
zero dollars, the United States is running a trade deficit and a deficit in its current account balance. (b) This shows the
same items—trade balance and current account balance—in relationship to the size of the U.S. economy, or GDP,
from 1960 to 2015.

By either measure, the U.S. balance of trade pattern is clear. From the 1960s into the 1970s, the U.S. economy had
mostly small trade surpluses—that is, the graphs in Figure 10.2 show positive numbers. However, starting in the
1980s, the trade deficit increased rapidly, and after a tiny surplus in 1991, the current account trade deficit became
even larger in the late 1990s and into the mid-2000s. However, the trade deficit declined in 2009 after the recession
had taken hold, then rebounded partially in 2010 and has remained stable up through 2016.

252 Chapter 10 | The International Trade and Capital Flows

Table 10.4 shows the U.S. trade picture in 2013 compared with some other economies from around the world. While
the U.S. economy has consistently run trade deficits in recent years, Japan and many European nations, among them
France and Germany, have consistently run trade surpluses. Some of the other countries listed include Brazil, the
largest economy in Latin America; Nigeria, along with South Africa competing to be the largest economy in Africa;
and China, India, and Korea. The first column offers one measure of an economy’s globalization: exports of goods
and services as a percentage of GDP. The second column shows the trade balance. Usually, most countries have
trade surpluses or deficits that are less than 5% of GDP. As you can see, the U.S. current account balance is –2.6% of
GDP, while Germany’s is 8.4% of GDP.

Exports of Goods and Services Current Account Balance

United States 17.6% –2.6%

Japan 16.2% 3.1%

Germany 46.8% 8.4%

United Kingdom 27.2% –5.4%

Canada 31.5% –3.2%

Sweden 45.6% 5.2%

Korea 45.9% 7.7%

Mexico 35.4% –2.9%

Brazil 13.0% –3.3%

China 22.1% 3.0%

India 19.9% –1.1%

Nigeria 10.7% -3.3%

World – 0.0%

Table 10.4 Level and Balance of Trade in 2015 (figures as a percentage of GDP, Source:
http://data.worldbank.org/indicator/BN.CAB.XOKA.GD.ZS)

10.3 | Trade Balances and Flows of Financial Capital

By the end of this section, you will be able to:

• Explain the connection between trade balances and financial capital flows

• Calculate comparative advantage

• Explain balanced trade in terms of investment and capital flows

As economists see it, trade surpluses can be either good or bad, depending on circumstances, and trade deficits can
be good or bad, too. The challenge is to understand how the international flows of goods and services are connected
with international flows of financial capital. In this module we will illustrate the intimate connection between trade
balances and flows of financial capital in two ways: a parable of trade between Robinson Crusoe and Friday, and a
circular flow diagram representing flows of trade and payments.

A Two-Person Economy: Robinson Crusoe and Friday
To understand how economists view trade deficits and surpluses, consider a parable based on the story of Robinson
Crusoe. Crusoe, as you may remember from the classic novel by Daniel Defoe first published in 1719, was

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253 Chapter 10 | The International Trade and Capital Flows

shipwrecked on a desert island. After living alone for some time, he is joined by a second person, whom he names
Friday. Think about the balance of trade in a two-person economy like that of Robinson and Friday.

Robinson and Friday trade goods and services. Perhaps Robinson catches fish and trades them to Friday for coconuts,
or Friday weaves a hat out of tree fronds and trades it to Robinson for help in carrying water. For a period of time,
each individual trade is self-contained and complete. Because each trade is voluntary, both Robinson and Friday must
feel that they are receiving fair value for what they are giving. As a result, each person’s exports are always equal
to his imports, and trade is always in balance between the two. Neither person experiences either a trade deficit or a
trade surplus.

However, one day Robinson approaches Friday with a proposition. Robinson wants to dig ditches for an irrigation
system for his garden, but he knows that if he starts this project, he will not have much time left to fish and gather
coconuts to feed himself each day. He proposes that Friday supply him with a certain number of fish and coconuts for
several months, and then after that time, he promises to repay Friday out of the extra produce that he will be able to
grow in his irrigated garden. If Friday accepts this offer, then a trade imbalance comes into being. For several months,
Friday will have a trade surplus: that is, he is exporting to Robinson more than he is importing. More precisely, he
is giving Robinson fish and coconuts, and at least for the moment, he is receiving nothing in return. Conversely,
Robinson will have a trade deficit, because he is importing more from Friday than he is exporting.

This parable raises several useful issues in thinking about what a trade deficit and a trade surplus really mean in
economic terms. The first issue that this story of Robinson and Friday raises is this: Is it better to have a trade surplus
or a trade deficit? The answer, as in any voluntary market interaction, is that if both parties agree to the transaction,
then they may both be better off. Over time, if Robinson’s irrigated garden is a success, it is certainly possible that
both Robinson and Friday can benefit from this agreement.

The parable raises a second issue: What can go wrong? Robinson’s proposal to Friday introduces an element of
uncertainty. Friday is, in effect, making a loan of fish and coconuts to Robinson, and Friday’s happiness with this
arrangement will depend on whether Robinson repays that loan as planned, in full and on time. Perhaps Robinson
spends several months loafing and never builds the irrigation system, or perhaps Robinson has been too optimistic
about how much he will be able to grow with the new irrigation system, which turns out not to be very productive.
Perhaps, after building the irrigation system, Robinson decides that he does not want to repay Friday as much as he
previously agreed. Any of these developments will prompt a new round of negotiations between Friday and Robinson.
Why the repayment failed is likely to shape Friday’s attitude toward these renegotiations. If Robinson worked very
hard and the irrigation system just did not increase production as intended, Friday may have some sympathy. If
Robinson loafed or if he just refuses to pay, Friday may become irritated.

A third issue that the parable raises is that an intimate relationship exists between a trade deficit and international
borrowing, and between a trade surplus and international lending. The size of Friday’s trade surplus is exactly how
much he is lending to Robinson. The size of Robinson’s trade deficit is exactly how much he is borrowing from
Friday. To economists, a trade surplus literally means the same thing as an outflow of financial capital, and a trade
deficit literally means the same thing as an inflow of financial capital. This last insight is worth exploring in greater
detail, which we will do in the following section.

The story of Robinson and Friday also provides a good opportunity to consider the law of comparative advantage,
which you learn more about in the International Trade chapter. The following Work It Out feature steps you
through calculating comparative advantage for the wheat and cloth traded between the United States and Great Britain
in the 1800s.

Calculating Comparative Advantage

In the 1800s, the United States and Britain traded wheat and cloth. Table 10.5 shows the varying hours of
labor per unit of output.

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254 Chapter 10 | The International Trade and Capital Flows

Wheat (in
bushels)

Cloth (in
yards)

Relative labor cost of
wheat (Pw/Pc)

Relative labor cost of
cloth (Pc/Pw)

United

States

8 9 8/9 9/8

Britain 4 3 4/3 3/4

Table 10.5

Step 1. Observe from Table 10.5 that, in the United States, it takes eight hours to supply a bushel of wheat
and nine hours to supply a yard of cloth. In contrast, it takes four hours to supply a bushel of wheat and three
hours to supply a yard of cloth in Britain.

Step 2. Recognize the difference between absolute advantage and comparative advantage. Britain has an
absolute advantage (lowest cost) in each good, since it takes a lower amount of labor to make each good in
Britain. Britain also has a comparative advantage in the production of cloth (lower opportunity cost in cloth (3/
4 versus 9/8)). The United States has a comparative advantage in wheat production (lower opportunity cost of
8/9 versus 4/3).

Step 3. Determine the relative price of one good in terms of the other good. The price of wheat, in this
example, is the amount of cloth you have to give up. To find this price, convert the hours per unit of wheat and
cloth into units per hour. To do so, observe that in the United States it takes eight hours to make a bushel of
wheat, so workers can process 1/8 of a bushel of wheat in an hour. It takes nine hours to make a yard of cloth
in the United States, so workers can produce 1/9 of a yard of cloth in an hour. If you divide the amount of cloth
(1/9 of a yard) by the amount of wheat you give up (1/8 of a bushel) in an hour, you find the price (8/9) of one
good (wheat) in terms of the other (cloth).

The Balance of Trade as the Balance of Payments
The connection between trade balances and international flows of financial capital is so close that economists
sometimes describe the balance of trade as the balance of payments. Each category of the current account balance
involves a corresponding flow of payments between a given country and the rest of the world economy.

Figure 10.3 shows the flow of goods and services and payments between one country—the United States in this
example—and the rest of the world. The top line shows U.S. exports of goods and services, while the second line
shows financial payments from purchasers in other countries back to the U.S. economy. The third line then shows
U.S. imports of goods, services, and investment, and the fourth line shows payments from the home economy to the
rest of the world. Flow of goods and services (lines one and three) show up in the current account, while we find flow
of funds (lines two and four) in the financial account.

The bottom four lines in Figure 10.3 show the flows of investment income. In the first of the bottom lines,
we see investments made abroad with funds flowing from the home country to the rest of the world. Investment
income stemming from an investment abroad then runs in the other direction from the rest of the world to the home
country. Similarly, we see on the bottom third line, an investment from the rest of the world into the home country
and investment income (bottom fourth line) flowing from the home country to the rest of the world. We find the
investment income (bottom lines two and four) in the current account, while investment to the rest of the world or
into the home country (lines one and three) is in the financial account. This figure does not show unilateral transfers,
the fourth item in the current account.

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Figure 10.3 Flow of Investment Goods and Capital Each element of the current account balance involves a flow
of financial payments between countries. The top line shows exports of goods and services leaving the home country;
the second line shows the money that the home country receives for those exports. The third …