May 12 2009

Deteriorating terms of trade and the current account balance

U.S. Trade Gap Widens on Oil Imports – WSJ.com

Terms of trade is a term that is often misunderstood by IB Economics students. Simply put, a nation’s terms of trade refers to the relative price of a country’s exports to its imports.

When a country’s imports increase in price, while the value of its exports stays the same, the country’s terms of trade are said to deteriorate. As a nation experiences deteriorating terms of trade, it finds itself moving towards a deficit in its current account, meaning that expenditures on imports are growing more than income from exports, also called a trade deficit.

The United States has run trade deficits for most years since 1970. Since 2004 the US has annually spent over $600 billion MORE on imports than it earned from the sale of its exports. (Balance of trade data going back to 1960 can be found here).

Usually, when a country enters a recession, it would be expected that its balance of trade would improve, since households demand fewer imports and domestic inflation decreases making the country’s products more attractive to foreign households. In fact, in 2008, when the US entered its current recession, its trade deficit actually decreased. Recently, however, due to the weakness of many of its trading partners and a deterioration in terms of trade, America’s recession is accompanied by a deepening trade deficit:

The U.S. trade deficit widened for the first time in eight months during March, as the price and use of imported oil both climbed.

The U.S. deficit in international trade of goods and services increased to $27.58 billion from February’s revised $26.13 billion, the Commerce Department said Tuesday. Originally, the February deficit was estimated at $25.97 billion.

U.S. exports in March slipped by 2.4% to $123.62 billion from $126.63 billion as trading partners bought less consumer goods and cars from the U.S. U.S. imports fell at a lower rate, dropping 1.0% to $151.20 billion from February’s $152.76 billion

Discussion Questions:

  1. How did rising oil prices lead to an increase in America’s trade deficit?
  2. What determines demand for American exports in the rest of the world? Why is demand for American goods and services falling even as their prices decline due to deflation in the US?
  3. Where does America get the money to buy hundreds of dollars more in imports than it sells in exports? What do foreigners do with all the US dollars they earn from their enormous trade surplus with the US?
  4. Why doesn’t the US government simply place tariffs or quotas on imports to try and achieve more balanced trade with the rest of the world? Is this an appropriate response to a trade deficit?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

6 responses so far

6 Responses to “Deteriorating terms of trade and the current account balance”

  1. Johnnyon 15 Feb 2010 at 2:21 am

    hmm. im a bit confused here.

    u said "As a nation experiences deteriorating terms of trade, it finds itself moving towards a deficit in its current account, meaning that expenditures on imports are growing more than income from exports, also called a trade deficit."

    isnt it the other way round?

    when Price of imports increase, due to the reverse J curve, it should therefore be elastic in the long run. This would lead to a decrease in the Value M in the current account, causing BOP to head out of deficit/into a surplus.

    Or is the assumption there that it causes a trade deficit in the short run?

  2. kennyon 14 Nov 2011 at 9:20 am

    How did rising oil prices lead to an increase in America’s trade deficit?

    well an increase in oil prices result in a shock to potential output . using a AD/AS model it shift the LRAS leftwards. that causes a expansionary gap. thus should the federal reserves do not intervene and the economy is left to self correct. the expansionary gap might result in an increase in imports.

    also an increase in oil prices result in increase prices of imports . assuming contant exports you will have imports more than exports . that result in a trade deficit.

    q2) What determines demand for American exports in the rest of the world? Why is demand for American goods and services falling even as their prices decline due to deflation in the US?

    foreigners determine the demand of american exports. mainly the exchange rate of the USD to the rest of the world. therefore a strong USD result in american exports to be expensive comparative to the foreign counterparts such as CHina . in addition with china able to produce at low costs. and beijing strict control over the RMB by keeping it undervalued. the american exports are always going to be more expensive . thus even with a deflation. the goods are seen as more expensive compare to developing countries produce.

    q3)Where does America get the money to buy hundreds of dollars more in imports than it sells in exports? What do foreigners do with all the US dollars they earn from their enormous trade surplus with the US?

    amercian get its money to buy its imports through the global savings glut. where by delveloping countries send their savings to developed countries like the USA. thus it result in excess supply of liquidty in the USA. thus interest rates are low in the USA. and that result in increase optisim , thus lending standards relaxed.

    the foreigners use all the foreign reserved and term them as their internationa foregn reserves. thus they use it for two purposes.

    firstly , they use it as a buffer for their domestic currency. should their currency suffer a speculative attack . they can use this extra USD and sell them to buy in the excess supply of domestic currency.

    secondly, they use the USD to lend to countires in crisis and earn interest on loan repayments.

    q4)Why doesn’t the US government simply place tariffs or quotas on imports to try and achieve more balanced trade with the rest of the world? Is this an appropriate response to a trade deficit?

    no this is not approipriate as shoudl the USA do that. its a form of protectionism. this may result in trading partners to retaliate by bycotting USA made products. result in zero exports. also foreigners may withdraw all FDI (foregin direct investements) from the USA. decrease I. a decreas in I and decrease in NX result in a decrease in AD and lower economic growth.

  3. jimlikesskion 28 Jan 2014 at 1:31 pm

    hi maddie

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    Deteriorating terms of trade and the current account balance | Economics in Plain English