Question

. Assume a U.S. firm buys (imports) $5 million (in U.S. dollars) of foreign goods. That transaction by itself increases the trade deficit by $5 million. But, the $5 million will flow back to the United States to purchase either (i) U.S. goods and services or (ii) U.S. assets. • How does the way the $5 million comes back to the United States determine whether there will be balanced trade or a trade deficit? • How does the U.S. economy benefit from either transaction (the foreign purchase of U.S. goods and services [exports] or the purchase of U.S. assets)?

Answer 1

Introduction:

When a country is importing more than it is exporting a trade deficit occurs. A trade deficit represents an outflow of domestic currency to foreign markets.

Every transaction a country makes with the world is summarized in the balance of payments. The balance of payments has two sub accounts:

The current account: Composed of goods and services

The capital and financial account: Composed of real and financial assets.

Answer 1.

a) The $5 million are used to purchase U.S goods and services.

In this case it is recorded on the current account as a positive number,this transaction compensates the $5 million that were recorded as a negative number and results in balanced trade.

b) The $5 million are used to purchase U.S assets

This is recorded on the capital and financial account as a surplus but even though this compensates the deficit on the current account, there is still a trade deficit.

Answer 2.

If the $5 million used to purchase foreign goods return as goods and services, it will benefit the nation by creating more jobs and generating more income for American producers.

If the $5 million return as U.S. assets (International investment) they will allow firms to expand and will help to finance the national debt.