NCPA - National Center for Policy Analysis

Trade Costs And The "Current Accounts Deficit"

March 8, 2001

When goods are shipped from outside the country they incur numerous additional costs including shipping, currency conversion, tariffs and costs associated with different product standards. These trade costs favor the consumption of domestic goods, and reduce capital flows from country to country.

But trade costs also have countervailing effects favoring international trade:

  • Differences in exchange rates can create large discrepancies in prices between domestically produced and imported goods.
  • This is the case with the dollar, which is strong against a devaluated euro, making foreign goods cheaper in the United States.
  • One consequence of greater consumption of foreign goods is that there is greater foreign investment in the U.S.; meanwhile, only 11 percent of Americans' equity investments are overseas, due to the inherent bias toward domestic investment caused by trade costs.

These factors are causing a "current account deficit" in U.S. trade. This deficit rarely gets very big before a correction takes place, and is relatively small when compared to total national savings and investment.

Typically, as a country increases its consumption of foreign goods, trade costs aggravate the current accounts balance and escalate domestic interest rates. A high interest rate tends to decrease the consumption of foreign goods in favor of domestic ones, and in turn reduces foreign investment, thereby shifting the current account back in the other direction.

Source: Matthew Davis, "Explaining the Mysteries of International Trade," NBER Digest, December 2000; based on Maurice Obstfeld and Kenneth Rogoff, "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?" NBER Working Paper No. 7777, July 2000, National Bureau of Economic Research, 1050 Massachusetts Avenue, Cambridge, Mass. 02138.

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