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Using fiscal policy to address trade imbalances

If a nation is experiencing the inflow of foreign investment capital associated with a trade deficit because foreign investors are making long-term direct investments in firms, there may be no substantial reason for concern. After all, many low-income nations around the world would welcome direct investment by multinational firms that ties them more closely into the global networks of production and distribution of goods and services. In this case, the inflows of foreign investment capital and the trade deficit are attracted by the opportunities for a good rate of return on private sector investment in an economy.

However, governments should beware of a sustained pattern of high budget deficits and high trade deficits. The danger arises in particular when the inflow of foreign investment capital is not funding long-term physical capital investment by firms, but instead is short-term portfolio investment in government bonds. When inflows of foreign financial investment reach high levels, foreign financial investors will be on the alert for any reason to fear that the country’s exchange rate may decline or the government may be unable to repay what it has borrowed on time. Just as a few falling rocks can trigger an avalanche; a relatively small piece of bad news about an economy can trigger an enormous outflow of short-term financial capital.

Reducing a nation’s budget deficit will not always be a successful method of reducing its trade deficit, because other elements of the national saving and investment identity, like private saving or investment, may change instead. In those cases when the budget deficit is the main cause of the trade deficit, governments should take steps to reduce their budget deficits, lest they make their economy vulnerable to a rapid outflow of international financial capital that could bring a deep recession.

Financing higher education

Over the period between 1982 and 2012, the increases in the cost of a college education had far outpaced that of the income of the typical American family. According to the research done by the President Obama’s staff, the cost of education at a four-year public college increased by 257% compared to an increase in family incomes of only 16% over the prior 30 years. The ongoing debate over a balanced budget and proposed cutbacks accentuated the need to increase investment in human capital to grow the economy versus deepening the already significant debt levels of the U.S. government. In the summer of 2013, President Obama presented a plan to make college more affordable that included increasing Pell Grant awards and the number of recipients, caps on interest rates for student loans, and providing education tax credits. In addition, the plan includes an accountability method for institutions of higher education that focuses on completion rates and creates a College Scorecard. Whether or not all these initiatives come to fruition remains to be seen, but they are indicative of creative approaches that government can take to meet its obligation from both a public and fiscal policy perspective.

Key concepts and summary

The government need not balance its budget every year. However, a sustained pattern of large budget deficits over time risks causing several negative macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary increase in the price level; crowding out private investment in physical capital in a way that slows down economic growth; and creating a dependence on inflows of international portfolio investment which can sometimes turn into outflows of foreign financial investment that can be injurious to a macroeconomy.

Problems

Sketch a diagram of how a budget deficit causes a trade deficit. ( Hint : Begin with what will happen to the exchange rate when foreigners demand more U.S. government debt.)

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Sketch a diagram of how sustained budget deficits cause low economic growth.

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Assume that you are employed by the government of Tanzania in 1964, a new nation recently independent from Britain. The Tanzanian parliament has decided that it will spend 10 million shillings on schools, roads, and healthcare for the year. You estimate that the net taxes for the year are eight million shillings. The difference will be financed by selling 10-year government bonds at 12% interest per year. The interest on outstanding bonds must be added to government expenditure each year. Assume that additional taxes are added to finance this increase in government expenditure so the gap between government spending is always two million. If the school, road, and healthcare budget are unchanged, compute the value of the accumulated debt in 10 years.

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References

The White House. “This is why it's time to make college more affordable.” Last modified August 20, 2013. http://www.whitehouse.gov/share/college-affordability.

Rubin, Robert E., Peter R. Orszag, and Allen Sinai. “Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray.” Last modified January 4, 2004. http://www.brookings.edu/~/media/research/files/papers/2004/1/05budgetdeficit%20orszag/20040105.pdf.

Questions & Answers

in one page explain the concept of market failure
Preshus Reply
what is Principle Economics
Hafiz Reply
outline price and production levels
Amokelane Reply
the disadvantage of monopolistic competition
Balam Reply
what is economics
Amara Reply
Economics is a social science which studies human behavior between ends and scarce means which has alternate uses
Evangelist
what is demand
Jattu Reply
what is windfall gain?
Bakshi
Demand may be defined as the amount of quantity of good and service which a consumer is willing to buy and with the ability to pay at a given price and ya a particular time
Afagami
What is captalizeg
Saminu Reply
What is socializing
Saminu
What is socializing
Saminu
What is socializing
Saminu
what is demand
Oforiwaa Reply
demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given period of time.
Modest
what is opportunity cost
Aboubakar Reply
what is gini coefficient?
Khalipha Reply
Never heard of that!!!!
Abdulrahmon
ive heard about it Actually i know it..
Shamamet
In that case, you have to help us.
Patrick
Another name for Absolute cost advantage
fatimah Reply
what is the difference between demand and supply
Peter Reply
what is the national income
Kamara Reply
oils and resources
Peter
it is the sum of all incomes earned by factors of production usually a year
C-Stixxs
What's current account?
Che Reply
Demand refers to goods and services that the buyer is willing and able to buy at a price over a period of time
Che
Can it be possible to have two level of comparative advantage in a country ?
Louise Reply
.no.its not possible
Asanda
Why ?
Louise
I think no possible
Sadiq
No
Nwanne
No resources are scare for a country to have a comparative advantage and it discourages external trade
C-Stixxs
each country are meant to Specialize on 1 production activities
C-Stixxs

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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