Trade Surplus

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Trade Surplus

A trade surplus occurs when a country’s trade balance is in surplus, or positive. The trade balance, which is also referred to as net exports, is the difference between the value of a country’s exports of goods (EX ) and services to other countries and the value of imports of goods and services from other countries (IM ):

TB = EX - IM

Thus, the trade balance is in surplus when exports exceed imports.

The trade balance is part of a country’s gross domestic product (GDP), which measures the market value of all final goods and services produced in a country. GDP is equal to the sum of the domestic residents’ absorption, A (which is given by the sum of private consumption, private investment, and government consumption), and net exports, TB. This implies that the trade balance can also be described as the difference between a country’s GDP and its domestic absorption:

TB = GDP - A

A country therefore runs a trade surplus when its gross domestic product exceeds its domestic absorption.

From an economic point of view, a trade surplus arises when the demand for a country’s export goods is higher than the country’s demand for import goods from the rest of the world. In the traditional, partial equilibrium view of trade flows, export demand depends positively on the economy’s price competitiveness, approximated by the real exchange rate, which is given by the ratio of the price of foreign goods to domestic goods (in foreign currency), and positively on aggregate demand conditions, which are approximated by foreign income. The idea is that when export goods are relatively cheap (i.e., price competitiveness is high), the demand for them will be higher. And when the income of foreign consumers increases they will also consume more goods, which will also increase the demand for the domestic economy’s export goods. By the same token, a country’s import demand is assumed to depend negatively on its price competitiveness and positively on domestic income. A country’s trade balance would therefore improve when a country experiences an improvement in its price competitiveness via a depreciation of its exchange rate or lower inflation than the rest of the world, or when domestic income expands at a slower pace relative to the rest of the world. Whether such developments will give rise to a trade surplus depends, of course, on how pronounced these developments are, on the strength of their effect on export and import demand, and on initial conditions.

Changes in domestic and foreign income and the exchange rate that influences the trade balance are in turn the result of macroeconomic fluctuations, such as a monetary policy or government expenditure shocks, which affect domestic and foreign economies. The textbook workhorse model for the analysis of the effects of such shocks is the Mundell-Fleming (MF ) model (Mundell 1968; Fleming 1962). The model assumes that prices are fixed in the short run, so that short-run production is demand determined. As a result, shocks to aggregate demand affect aggregate income and the real exchange rate and thereby the trade balance via their effect on export and import demand as well as relative prices. The net effect of macroeconomic shocks on the trade balance in the MF model is not always clear-cut and also depends on the exchange rate regime in place. For a textbook exposition of the Mundell-Fleming model see Paul R. Krugman and Maurice Obstfeld (2006).

The more recent class of models of the so-called “New Open Economy Macroeconomics” (NOEM) also builds on the assumption of short-run price stickiness in the analyses of the effects of macroeconomic shocks on the dynamics of exchange rates, trade balances, and other macroeconomic variables. The NOEM models are based on a microfounded intertemporal optimising model framework (see Obstfeld and Rogoff 1995 and 1996 and for an overview of the NOEM framework Lane, 2001). In this setup, trade balance surpluses (deficits) arise because of consumption smoothing. The trade balance is essentially the buffer that allows a country to insulate consumption from short-run income fluctuations. While the assumption of short-run price rigidity is similar to the fix price assumption in the Mundell-Fleming model, the implications of the NOEM framework can differ substantially. The effect of macroeconomic shocks on the trade balance depends in these models on many factors, like the assumptions made regarding the pricing scheme of export firms, the degree of home bias in consumption, whether shocks have been expected or not, or whether they are expected to be transitory or permanent.

Movements of the trade balance are closely linked to financial flows between countries. This becomes clear when looking at the balance of payments identity. The balance of payments records all of a country’s transactions with countries abroad and is equal to the current account balance (CA ) plus the capital account balance (KA ) less the change in a country’s net foreign reserves (Δ FR ) and is by definition equal to zero:

BP = CA + KA - Δ FR = 0

The capital account balance records all of a country’s capital transactions with countries abroad (sales and purchases of assets), and the change in foreign reserves is the change in a country’s central bank holding of gold and foreign exchange. The current account balance records all of a country’s current transactions with countries abroad including trade in goods and services and a country’s net factor income from abroad; that is net factor income earned on the return on capital invested abroad and net international income receipts, NFI :

CA = TB + NFI.

The previous two equations show that, as part of the current account, the trade balance is an important determinant of a country’s net foreign asset position, because the current account balance is equal to the change in its net foreign asset position, which is given by the change in foreign reserves less the capital account balance.

When a country exports more to the rest of the world than it imports (i.e., the country is a net exporter and runs a trade surplus), it produces more than it consumes and sells this production surplus to the rest of the world. In order to finance the transaction, the country is lending to the rest of the world and, as a consequence, improves its net foreign asset position by accumulating foreign assets or repaying outstanding debts that were received from the rest of the world in earlier periods.

The trade balance is an important determinant of a country’s international solvency. The previous equation illustrates that the sum of a country’s trade surplus and its net international income receipts equal the country’s current account balance. This implies that if a country runs perpetual current account deficits, its net foreign asset position is negative and the country is a net debtor to the rest of the world. Thus, the country must generate trade balance surpluses in the future in order to service its foreign debt obligations. Therefore, the international solvency and creditworthiness of a country depends on its ability to meet its foreign debt obligation by generating trade balance surpluses in the future.

SEE ALSO Balance of Payments; Balance of Trade; Exchange Rates; Macroeconomics; Mercantilism; Mundell-Fleming Model; Trade Deficit