According to Gregory Mankiw (2011), trade balance reflects the difference between net worth of exports and imports in a given country. Consequently, positive trade balance suggests in monetary value country exports more than it imports, while negative trading balance (trade deficit) is associated with dominance of imports over exports. Economists argue that trade deficit is not always considered to have a negative impact on the national economy, however it often creates potential risks which may result in harsh economic consequences if they are not addressed properly. For example, if net exports are negative it is assumed that proceedings from exports are insufficient to cover the expenses associated with imports. Thus, government has to cover this gap through reducing its currency reserves or seek additional funding elsewhere. If the gap between the value of imports and exports cannot be covered, domestic currency may depreciate, making import goods more expensive to the regular customers.
Modern economic policy offers a number of measures which could be implemented in order to reduce an adverse trade balance in a given country. The intuition in this case is straightforward: to avoid substantial trade deficit, a country should impose policies which are either aimed at the reduction of imports and (or) increase in exports. Several of these measures are discussed by David Romer (2005).
First set of measures are called expenditure switching policies. The aim of these policies is to attract consumer towards the purchase of domestic goods as opposed to import goods. For instance, government may impose import controls which will increase the price of import goods in a given country, thus decreasing the demand for them. As a result, amount of imports will be decreased. In addition, in countries where exchange rate is controlled by a Central Bank, artificial depreciation of the currency rate may solve the problem of the trading deficit. As national currency depreciates, domestic goods become relatively cheaper as opposed to import ones. Consequently, a country may gain advantage in increasing its exports and limiting its imports. It should be noted, however, that an increase in import prices may be the cause of increasing inflation rates if economy has large portion of import goods in its consumption pattern.
Second set of measures may be referred as measures which are aimed at increasing domestic competitiveness. The setup of incentives for domestic industries to improve their competitiveness may naturally lead to the increase in exports and decrease in imports, as local consumers will start favoring domestic products. Such incentives may be created by imposing tax reductions to certain industries or providing government subsidies to companies to increase R&D investment.
Finally, in the times of high inflation and and adverse trade account deficit, a government may apply certain contractionary measures which are imposed in order to slow down the overheating economy. In such instances higher levels of wealth of consumers lead to an increase in aggregate demand which could not be supported by production capacities. Hence, this gap between production capacities and excess demand creates a surge in inflation rate. If this situation is accompanied by large amount of imports as opposed to little amount of exports, huge trade account deficit may accumulate. As a result, government may try to reduce the aggregate excess demand by increasing taxes and interest rates. These measures usually result in decrease of the money supply and make corporate and personal borrowing less attractive. Consequently, overall expenditure in a country shall fall, as well as expenditure on import goods. This would stabilize trade account deficit.
If country A has a higher rate of growth of national income compared to country B it may create incentives to invest into country A since consumers in country A are increasing their wealth faster than those of country B. However, in absolute terms citizens of country B may be much richer than those of country A. Investment decision would largely depend on the type of good which would be produced by the factory, institutional environment, tax regulations etc. For example, consider the growth rate of national income in Sierra Leone and United States (data from World Bank):
Sierra Leone has an average growth rate which is much higher than that of the US, however it could not serve the main reason to build a factory there. In addition high levels of national income growth may signal about the possible overheating in the economy, which are often followed by recessions and economic downturns. Overall, it is impossible to make a qualitative investment decision which is just based on the growth rates of national income. There are many factors which also should be taken into consideration.
If Country B has a higher level of investment subsidies for business investment compared to Country A, it is a very strong argument in favor of building a factory in country B. Investment subsidies will contribute to the expansion of production in a given country, thus increasing the scale of business and increasing potential revenues (as well as decreasing costs). Besides, company may enjoy the effects of increasing returns to scale. According to The Economist (2007), such kind of policy was imposed by Singapore’s government in the early 80-ies, when country was striving to attract foreign direct investment from all over the world. Singapore’s government claims that this policy along with attractive macroeconomic environment led to substantial increase in investments in the following years.
The other scenario when the government of Country A have announced that they are going to pursue contractionary macroeconomic policies whereas, in country B, the government has announced it is going to implement expansionary macroeconomic policies, could also have major impact on the investment decision. According to Jane Gravelle (2012), contractionary policy is applied when economy has a risk of “overheating”. Government imposes contractionary policy through the decrease in money supply, by increasing the interest rates and reserve requirements for the banks. As a result, it becomes more difficult for the industries to attract financing and expand their businesses. This allows to reduce inflation and decrease the risk of over-production crisis. However, there are no gains from such a policy for regular investor
On the contrary, expansionary policy leads to the reduction of interest rates, corporate taxes and increase in money supply. This suggests that firms can take attract capital at lower rates, which creates incentives to expand production and increase investments. Expansionary policy reduces businesses’ costs associated with expansion, and as a result such country shall experience increase in the Foreign Direct Investments.
List of References
Mankiw, N. Gregory. Principles of Economics. 4th ed. Mason, OH: Thomson/South-Western, 2007.
Romer, David. Advanced Macroeconomics. 3rd ed. Boston, Mass.: McGraw-Hill, 2006.
Gravelle, Jane. Can Contractionary Fiscal Policy Be Expansionary? CRS Report for Congress. 2012.
Singapore’s Economy: The High Flyer. The Economist. Web. Oct. 25th, 2007.
World Bank. Key Macroeconomic Indicators. Web. 2013.