The balance of trade is one of the key components of a country's gross domestic product (GDP) formula. GDP increases when there is a trade surplus: that is, the total value of goods and services that domestic producers sell abroad exceeds the total value of foreign goods and services that domestic consumers buy. If domestic consumers spend more on foreign products than domestic producers sell to foreign consumersa trade deficitthen GDP decreases.

A standard formula for GDP can be written as follows:

﻿ $GDP = \text{private consumption spending} + \text{investments} + \text{government spending} + \left( \text{exports} - \text{imports} \right)$﻿

## Understanding the Balance of Trade

Very few economic subjects have caused as much confusion and debate as the balance of trade. This confusion is driven by the language involved in reporting a country's net trade in final goods; "trade deficit" sounds bad, while "trade surplus" sounds good.

As long as exchange rates are free-floating, however, trade imbalances never really exist in the long run. Even if they did, there is little reason to believe they would have negative consequences.

Suppose the United States ran a $100 million trade deficit with Germany, largely because Americans liked German cars more than Germans liked American cars. The payments, in dollars, made by Americans to German automakers would eventually come home in the form of dollar assets. By buying German cars, Americans have sold dollars to the Germans. In return, the Germans can buy assets such as Treasury bills (T-bills) or U.S. real estate. So, even though the U.S. GDP would fall by$100 million, the American economy is no worse off (and has actually benefited from) the net exchange.

In addition, there are some issues with GDP overall. GDP measures the dollar value of finished goods and services in an economy; it is presented in terms of what consumers spent. It does not measure how efficiently an economy produces goods, whether standards of living are rising or if productive capital investments have been sufficiently made.