A:

The balance of trade is one of the key components of a countries gross domestic product (GDP) formula. GDP increases when the total value of goods and services that domestic producers sell to foreigners exceeds the total value of foreign goods and services that domestic consumers buy, otherwise known as a trade surplus. If domestic consumers spend more on foreign products than domestic producers sell to foreign consumers – a trade deficit – then GDP decreases.

A standard formula for GDP can be written as: GDP = private consumption spending + investments + government spending + (exports - imports).

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.

Even though GDP would fall by $100 million, the American economy is no worse off (and has actually benefited from) the net exchange. The Germans sold cars to Americans in exchange for the Americans selling dollars for Germans, so that the Germans could hold assets such as Treasury bills (T-bills) or real estate.

Some Issues with GDP

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.

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