Question

Consider the case of a gold standard economy with no capital mobility. In the absence of international capital mobility, is a trade deficit sustainable? How would central bank reserves change if the country ran a trade deficit? What would be the effects on the money supply? How would output and employment change, and what would be the effects on the trade balance?

Ref book international Macroeconomic by Montiel

Answer 1

A trade deficit exists when a nation’s imports exceed its exports. In order for a trade deficit to take place, foreign countries must provide loans or investments, which they are willing to do because they expect they will be repaid eventually (that the deficit will become a surplus). If there is no capital mobility interntionally, there is no way to ensure the repayment of this "loan", and hence, trade deficit is not sustainable.

In this scenario, the payments need to be made with central bank reserves, and hence they would run down.

Clearly, if the reserves decline, money supply will also decline, which would lead to a contraction cycle, leading to a decrease in output and employment. Trade balance would further decline in this scenario.