Trade Deficit: Meaning, Causes, Effects, Advantages, Disadvantages, and More

Trade Deficit: Meaning

Trade Deficit occurs when the imports of the country are higher than the exports of the country. It is a situation where the country is buying more from other countries and selling less to other countries. Generally, the calculation of Trade Deficit takes place on annual basis, but it can be for a shorter run as well. Mostly, at the end of the year, it is checked whether imports have exceeded exports or vice versa. An International Transaction Account (also known as Balance of Payments), records all economic transactions between the residents and non-residents of the country.

The other name of Trade Deficit is Negative Balance of Trade (BOT).

Understanding Trade Deficit

All international transactions of goods, services, and a combination of goods and services are considered in the calculation of the Trade Deficit. Balance of Payment of country majorly consists of a current account, capital account, and financial account. The current account records all tangible and intangible transactions between countries. If the current account shows a negative balance then there is a Negative Balance of Trade in the current account. Similarly, the capital account records all capital expenditures. It measures inflows and outflows of funds in the form of capital expenditure from one country to another. A deficit in capital account shows that there is more capital outflow, than the inflow in the economy.

Financial account measures the transaction of financial assets by residents and non-residents of the country. A surplus financial account means that more foreign investors are investing in domestic financial assets. A deficit financial account depicts that domestic investors are investing in foreign financial assets.

Trade Deficit: Formula

The formula for calculating Trade Deficit is as follows:-

Trade Deficit ($) = Total Value of Exports ($) – Total Value of Imports ($)

Causes and Effects of Trade Deficit

Following are a few causes and effects of Trade Deficit:-

Causes

Trade Deficit, majorly occurs because of two situations, which are as follows:-

The first situation is when the domestic country is not producing enough goods and/or services within the boundaries of the country. Hence, in order to meet the domestic demands, the country would be extensively importing goods and/or services from other countries. In this situation, the imports will always exceed the exports of the country

The second situation is when due to technological, capital requirements, local rules and regulations, and other factors the finished goods are manufactured and supplied by the foreign countries. But the raw material for those finished goods is exported from the domestic country. In such a situation, the country exports the raw materials but at the same time imports the finished goods. Since the addition of utility takes place on finished goods, the value of imports tends to be higher than the value of exports.

These causes (which are non-exhaustive in nature) boost the Trade Deficit of the country.

Effects

There are many outcomes or effects of Trade Deficit. They are as follows:-

A country with a Negative Balance of Trade, demands a lot of foreign exchange in order to fill the gaps between exports and imports of the country. As a result of the high demand for foreign exchanges, the domestic currency weakens over a period of time.

As there are high imports in the country, the citizens of the country get a variety of products at competitive prices. Excessive dependence on imported goods leads to less demand for domestic goods. All these things ultimately lead to less domestic production, less industrialization.

Such a situation, in turn, leads to various financial anomalies and adverse effects on the local economy and the public at large. These can be lesser utilization of local resources-raw materials, minerals, human capabilities, unemployment issues, law and order issues, etc. Due to low production, lesser avenues for taxation for the Government leads to higher taxation on the public in terms of taxing goods and income. Moreover, lesser spend on infrastructure and development of the country.

These effects (which are non-exhaustive in nature) are the result of the Negative Balance of Trade of the country.

trade deficit

Advantages of Trade Deficit

  • Trade Deficit provides a variety of products and services, at a competitive price to the citizens of the country.
  • In the initial stages of the Negative Balance of Trade, the standard of living of the citizens of the country improves.
  • In the short run, a Negative Balance of Trade helps the company in overcoming the scarcity of goods and services.
  • There exists less risk of inflation in the country, due to competitive prices.
  • With the help of imports, the domestic country gets an opportunity to consume more than its normal production capacity.
  • In most cases, a Negative Balance of Trade encourages additional Foreign Direct Investment in the country.

These advantages are non-exhaustive in nature.

Disadvantages of Trade Deficit

  • As the imports of the country are higher than the exports of the country, there is a reduction in domestic production. Lesser domestic production leads to a situation of unemployment.
  • Negative Balance of Trade (BOT) might lead to lower Gross Domestic Product (GDP) due to a lesser production level.
  • Trade deficit leads to the weakening of the domestic currency.
  • A negative Balance of Trade might further lead to a deflationary situation.
  • Negative Balance of Trade outsources jobs to other countries. This is because of a reduction in domestic production.
  • In the midst of attracting more Foreign Investments in the country, the government might put its assets and resources at stake. The government attracts FDIs to bridge the trade gap.

These disadvantages are non-exhaustive in nature.

Trade Deficit Vs Trade Surplus

When exports are more than the imports of the country, there is a Trade Surplus. In contrast to this, if imports are higher than the exports, there is Trade Deficit. Mostly, a surplus situation is positive and a deficit situation is negative. A country with a Trade Surplus mostly has a higher domestic production in comparison to, a Negative Balance of Trade. Trade Surplus, reaps in a lot of foreign exchange. Trade Deficit does not reap much foreign exchange. Generally, Trade Surplus creates domestic employment, and a Negative Balance of Trade does not generally create employment.

Although excessive of both the situations is not feasible for any country.

Trade Deficit Vs National Debt

Deficit and Debt are both macro-finance terminologies, which are often confused as the same. National Debt is the money owed by the country to some financial institution or a country or any other statutory body. Deficit shows the variations in the Balance of Payments. National Debt is mostly for the long term and Deficit is for the comparatively short term. Trade Deficit generally depicts weak economic conditions, while National Debt does not directly imply weak economic conditions. Mostly the Deficit for years combines to form a National Debt.  

Conclusion

According to experts, Trade Deficit is beneficial only in the short term. In the short run, a Negative Balance of Trade helps the country to overcome inflation and provides the citizens of the country with a variety of products. In the short term, the standard of living of citizens of the country improves and they also get access to competitive products at competitive prices. According to the experts, a Negative Balance of Trade is not beneficial in long run. In the long run, the Negative Balance of Trade hampers the domestic production capacity of the country, thereby hampering the employment situation. Eventually, it devalues the currency, and the inflation scenario takes place in the country. Thus Trade Deficit is favorable only in a shorter duration, as it mostly overcomes all the limitations.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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