Problem 7 Why does the trade balance and t... [FREE SOLUTION]

Chapter 10: Problem 7

Why does the trade balance and the current account balance track so closely together over time?

Short Answer

Expert verified

The trade balance and the current account balance track closely together because the balance of trade (exports minus imports) is a major component of the current account. Changes in exports and imports directly affect the trade balance and have a significant impact on the current account balance. While primary and secondary income also impact the current account, fluctuations in trade typically have the most significant effect. This close correlation helps policymakers and economists understand a country's international transactions, financial position, and economic policy.

Step by step solution

Define Trade Balance

Trade balance refers to the difference between a country's exports and imports of goods and services. It is calculated as the total value of exports minus the total value of imports. A positive trade balance indicates a trade surplus (exporting more than importing), whereas a negative trade balance indicates a trade deficit (importing more than exporting).

Define Current Account Balance

The current account balance is a measure of a country's international transactions and includes not just trade but also income and current transfers. It is the sum of the balance of trade (exports minus imports of goods and services), net primary income (income from factors of production, such as wages and investment income), and net secondary income (current transfers between countries, such as remittances and foreign aid).

Identify Components of the Current Account

The main components of the current account are: 1. Balance of trade (exports minus imports of goods and services) 2. Net primary income (the difference between income received from abroad and income paid to foreign residents) 3. Net secondary income (the difference between current transfers received from abroad and current transfers paid to foreign residents)

Explain the Close Correlation

The trade balance and the current account balance track closely together because the balance of trade is a major component of the current account. Changes in exports and imports, which affect the trade balance directly, will also have a significant impact on the current account balance. In other words, when a country experiences a trade surplus (exporting more than importing), its current account balance will usually improve (increase), and vice versa when it experiences a trade deficit (importing more than exporting). Although primary and secondary income can also impact the current account balance, fluctuations in trade (exports and imports) typically have the most significant effect on the current account. This close correlation between the trade balance and the current account balance can be observed across different countries and over time. It helps policymakers and economists in understanding a country's international transactions, financial position, and economic policy.