Balance of payments ; International trade ; Economic conditions - United States ; Dollar, American

Carl Walsh

English

Research Papers in Economics

FRBSF
March 6, 1987 WEEKLY LETTER
The Trade Balance and the Economic Outlook
Since the value of the u.s. dollar peaked in Feb-
ruary 1985, economic commentators have been
waiting anxiously for the u.s. trade balance to
improve. The failure of the trade balance to turn
around has been held responsible for dampen-
ing GNP growth, while continued expectations
of its eventual improvement form the basis of
optimistic forecasts of future GNP growth.
Unfortunately, the discussion of the relationship
between the trade balance and domestic eco-
nomic growth has generally failed to specify
clearly the driving forces behind the expected
trade improvement. This Letter attempts to clar-
ify the relationship between the trade balance
and the level of domestic economic activity by
focusing on three possible factors that have fig-
ured prominently in recent discussions: U.S. fis-
cal policy, U.S. monetary policy, and policy
actions by our major trading partners - Japan
and West Germany in particular.
Depending on which of these fundamental
forces is causing the economy to adjust, an
improved trade balance and more rapid growth
may develop. But an improved trade balance
and less rapid growth is a combination that can
also easily arise. Moreover, this latter outcome is
particularly likely to be produced byexpendi-
ture cuts designed to reduce the federal budget
deficit.
In general, no systematic relationship between
net exports and economic growth should be
expected. The chart shows the annual growth
rate of u.s. real GNP since 1970 together with
the real value of the current account. The cur-
rent account is equal to the net trade balance of
goods and services plus net remittances, pen-
sions, and other unilateral transfer payments.
Strong output growth has been associated with
both an improving current account, asin 1978,
and a worsening current account, as in 1984.
Reasons
If we wish to draw the correct implications
about a current account improvement for GNP
growth, it is necessary to understand the forces
bringing about the current account
improvement.
First, though, a word about the most frequently
mentioned reason to expect a rise in our net
exports - the fall in the value of the dollar. As
the dollar declines in value against other curren-
cies, U.s.-produced goods become cheaper rela-
tive to foreign-produced goods. This will tend to
increase U.s. exports as foreigners increase their
demand for cheaper u.s. goods; and it will tend
to decrease U.s. imports as U.s. consumers sub-
stitute U.s. products for the more expensive for-
eign goods. Net exports should eventually rise in
response to the fall in the value of the dollar.
The problem with this explanation is that it fails
to specify the reason for the fall in the dollar's
value! As will be seen from the examples dis-
cussed below, a falling dollar and rising net
exports can be associated w,ith stronger real eco-
nomic growth, or with weaker growth. It all
depends on what causes the exchange rate, the
trade balance, and real growth to adjust.
U.S. fiscal policy
Changes in the stance of fiscal policy in the u.s.
will affect the value of the dollar, u.s. net
exports, and the level of domestic economic
activity. To understand the effects of fiscal pol-
icy, it is useful to distinguish between current
policy changes and expected future policy
changes.
A contractionary fiscal policy designed to
reduce the current federal budget deficit is one
exampleof a policy that is likely to improve the
trade balance, yet lead to slower real growth.
For example, a reduction in government pur-
chases of goods and services will directly lower
the demand for domestic output and reduce the
borrowing needs of the government. A decline
in the government's borrowing needs will tend
to put downward pressure on market interestFRBSF
rates. As U.s. interest rates decline relative to
rates of return available in other countries, so
will the value of the u.s. dollar.
The resulting decline in the dollar will tend to
stimulate U.S. exports, but not to the extent of
offsetting the contractionary effect ofthefiscal
policy. Slower growth will result in the short-
run.
This scenario is the reverse of what many ana-
lysts claim occurred during the first half of the
1980s. At that time, expansionary fiscal policy,
consisting of tax cuts in 1981 and the rapid
increase in defense spending, generated high
real interest rates, a strong dollar, and a trade
deficit at the same time that it helped move the
economy out of the 1982 recession. Thus, faster
growth was accompanied by a deterioration in
the trade balance.
Perhaps more pertinent to our understanding of
the effect of fiscal policy in the current environ-
ment are the effects, not of current fiscal actions
to reduce the budget deficit, but of expectations
of future actions to reduce the budget deficit.
Over the last year, forecasters have generally
lowered their deficit projections for the rest of
the 1980s and into the 1990s. Instead of projec-
tions of $200 billion deficits for many years to
come, projections show the federal deficit
declining gradually over the next several years.
If actual fiscal policy changes affect current
short-term interest rates, then the expectation of
a change in future deficits should affect expecta-
tions of future short-term interest rates. Interest
rates on long-term assets reflect both current
short-term interest rates and the market's expec-
tations of future short rates over the life of the
long-term asset. Consequently, changes in
expected future short-term rates will influence
the current level of long-term rates.
Through this "expectational" channel, expecta-
tions offuture contractionary fiscal policy are
likely to reduce the current level of interest rates
in the U.S. Since investing in U.s. financial
assets would become less attractive, the fall in
interest rates would also lead to a depreciation
ofthe dollar against other currencies. This fall in
the dollar would eventually produce a rise in net
exports.
Because the dollar would not be declining as the
result of a reduction in any other component of
the demand for u.s. goods and services, the rise
in net exports would represent a net increase in
the demand for our output. The rise in net
exports also would stimulate U.s. production
and lead to stronger growth. This case differs
from the effects induced by a current fiscal con-
tractionsince the actual decline in government
spending occurs in the future, that is, there is no
simultaneous decline in government purchases
to offset the rise in net exports.
U.S. monetary policy
U.s. monetary policy can also affect the trade
balance. For example, an expansionary mone-
tary policy that temporarily lowers U.s. interest
rates will also tend to produce a fall in the value
of the dollar. The dollar's fall, in turn, will stimu-
late U.S. exports and reduce our imports by
making foreign goods relatively more expensive.
The improved trade balance that would result
from an expansionary U.s. monetary policy
represents a net increase in the demand for u.s.
output. Domestic production will rise in
response. This exchange rate-induced improve-
ment in the trade balance is one of the channels
through which a monetary expansion leads to
increased economic growth.
Foreign economic expansion
Recent press accounts on the trade deficit have
stressed the attempts by the Reagan Administra-
tion to pressure japan and West Germany into
adopting more expansionary policies. Increased
growth in these two major economies would
presumably increase the demand for U.S. goods
and services and thereby cut our trade deficit
and stimulate growth in the u.s. "For U.S.
exports to grow, the economies of our trading
partners must grow", according to President
Reagan in this year's Economic Report ofthe
President. However, this rosy outcome may
depend crucially on the economic policies those
countries use to generate increased growth.
A japanese fiscal expansion, for example, would
lead to the desired result of a reduced trade defi-
cit and increased economic growth for the U.S.
The japanese expansion would tend to raise
interest rates in japan and drive up the value of
the yen. By making japanese-produced goods
more expensive, the stronger yen would reduce
u.s. imports of japanese goods, while simul-
taneously increasing the demand by japan for
u.s. goods. This increase in our net exports,
since it would not be offset by a decline in any1970 1972 1974 1976 1976 1960 1982 1984 1986
No Systematic Relationship Between
the Current Account and Economic Growth
other component of demand, would stimulate
growth in the u.s.
Lessons
A fall in the value of the dollar should improve
our trade balance, but whether that improve-
ment is associated with faster GNP growth will
depend on the cause ofthe dollar decline. Fiscal
action to reduce the current federal budget defi-
cit will contribute to a rise in net exports, but
such a policy will also tend to slow real growth.
Expected fiscal deficit reduction in the future or
current expansionary monetary policy will both
work to lower the trade deficit and to stimulate
real growth.
Understanding the connection between move-
ments in the trade balance and the outlook for
growth requires a consideration ofthe forces
causing the current fall in the value ofthe dollar.
These forces may include expectations of tighter
u.s. fiscal policy in the future and current mar-
ket perceptions of some monetary stimulus. In
principle, such a policy combination implies
that the induced fall in the dollar and rise in net
exports should result in a net gain for u.s.
growth.
These separate policies can be combined in
ways that may contribute to an improved trade
balance while strengthening real growth. For
example, a tighter domestic fiscal policy accom-
panied by easier domestic monetary policy
would work towards reducing the trade deficit
without producing the slower growth that would
result from a fiscal contraction alone.
However, because the future eventually
becomes the present, policymakers must even-
tually takethe contractionary fiscal steps neces-
sary to reduce the budget deficit. To avoid
producing slower growthand to improve the
trade balance further, such steps mayrequire the
simultaneous implementation of an easier mone-
tary policy.
The effects of an economic expansion among
our trading partners on u.S. growth will depend
on the particular policies used by those coun-
tries. More expansionary fiscal policy in japan
and/or Germany should improve our trade bal-
ance and stimulate growth in the u.s. An expan-
sion induced by monetary growth, however,
may lead to a much smaller improvement in net
exports and could even worsen our trade deficit.
-120
-2
The adverse effect on our growth and our trade
balance of aforeign expansion fueled by mone-
tary growth would be offset somewhat by the
effects of the expanding income abroad. The
above-mentioned expansion in japan generated
by monetary policy would tend to produce a rise
in U.s. exports as income in japan rises. This
rise in U.s. exports may dominate the impact of
the falling yen, and lead to an improvement in
U.s. net exports. Clearly, the expansionary effect
on the u.s. of greater growth abroad will
depend crucially on the particular policies our
trading partners adopt to expand their
economies.
The outcome could be quite different ifjapan
decided to stimulate its economy through the
use of expansionary monetary policy. In recent
months, some u.s. officials have suggested that
the Bank ofJapan should cut its discount rate.
On February 23, the Bank of japan announced a
reduction in its discount rate from 3 percent to
2V2 percent. Such a cut will tend to reduce the
general level of interest rates in japan and pro-
duce a drop in the value of the yen. But a fall in
the yen makes japanese goods less expensive
and tends to reduce u.s. exports to japan while
increasing our imports from Japan. The results
are a worsening of our trade balance and a
slowing of u.s. growth.
01-N---+--+------++-+---+----T-.-------I
Annualized Growth Billions$
Rate (Percent) Annual Rate
10 40
8
0
6
-40
4
2 -80
Carl Walsh
Opinionsexpressed in this newsletterdo notnecessarily reflect theviews ofthe managementofthe Federal Reserve BanI< ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor•...FreecopiesofFederal Reserve publications
can beobtained from the Public Information Department, Federal Reserve Bankof San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!4S0m 4o~n U060JO OpOA0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and liabilities
Large Commercial Banks
Amount
Outstanding
2/11/87
Change
from
2/4/87
Change from 2/12/86
Dollar Percent!
Loans, Leases and Investments1 2 205,365 - 824 3,292 1.6
Loans and Leases1 6 184,344 - 790 1,838 1.0
Commercial and Industrial 54,339 - 461 1,362 2.5
Real estate 67,845 100 1,768 2.6
Loans to Individuals 38,059 - 19 - 2,325 - 5.7
Leases 5,459 - 29 - 229 - 4.0
U.S. Treasury and Agency Securities2 13,943 10 2,729 24.3
Other Securities2 7,078 - 45 - 1,276 - 15.2
Total Deposits 206,749 - 2,333 6,502 3.2
Demand Deposits 51,611 - 2,116 5,270 11.3
Demand Deposits Adjusted3 35,741 - 504 3,310 10.2
OtherTransaction Balances4 19,269 - 361 4,331 28.9
Total Non-Transaction Balances6 135,869 145 - 3,099 - 2.2
MoneyMarket Deposit
Accounts-Total 46,909 13 1,336 2.9
Time Deposits in Amounts of
$100,000 or more 32,431 91 - 6,661 - 17.0
Other Liabilities for Borrowed MoneyS 24,824 141 - 751 - 2.9
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+J/Deficiency(-)
Borrowings
Netfree reserves (+J/Net borrowed(- J
Period ended
2/9/87
111
6
106
Period ended
1/26/87
67
15
52
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes u.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change

The trade balance and the economic outlook

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The trade balance and the economic outlook

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