Question

What is a trade deficit? How is a trade deficit related to the net inflow of foreign capital? Is a trade deficit bad? Why or why not?

Answer 1

Trade deficit occurs when imports are more than exports in an economy in a given time period.

It means the economy is purchasing more goods and services than it is selling to the rest of the world.

Trade deficit of Current account deficit means the overall money is going out of the country. While net capital inflow means overall the money is coming into the country.

Since the sources of cash must match the uses of cash to keep the balance of payments, the trade deficit is equal to the net capital inflow.

In the short run trade deficit is actually useful as it allows the countries to consume beyond their production possibilities.

In the long run however trade deficit creates many problems like losing ownership over resources to foreign investors, problems with balance of payments which can further lead to problems with foreign exchange.