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The speed at which faster money
growth translates into higher inflation
depends on expectations and on the
amount of slack in the economy. When
inflation expectations are widespread
or when little capacity is available to
accommodate foreign demand through
increased output, faster money growth
translates quickly into higher prices.
Under such conditions, faster money
growth might not result in even a transitory improvement in the trade balance.
Similar comments apply to the policy
of encouraging growth in Japan and
Germany. Such policies seek to increase
demand for U.S. goods and services. If
the United States is operating below
full capacity, U.S. manufacturers can
satisfy the increased demand through
additional production. If the economy is
operating at full capacity, however,
prices in the United States will rise to
choke off the increase in demand. The
trade balance will not improve.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OR 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Conclusion
Any near-term success from promoting
a dollar depreciation and encouraging
faster growth abroad will owe much to
the fact that the U.S. economy is not
operating at full capacity. With unused
resources, the increased demand for
U.S. goods can generate increased production, employment, and real income.
The higher income could generate savings and could help reduce the government budget deficit.
Economists, unfortunately, are not
adept at measuring capacity or at predicting when capacity constraints will
become binding. Although we do not expect that the United States soon will
experience capacity constraints, the
unemployment rate is reaching levels
that many economists associate with
"full" or noninflationary employment,
and many economic forecasts now expect inflation to accelerate, although
modestly.

Once the U.S. economy reaches full
capacity, resources will be unavailable
to satisfy foreign demand, and domestic
prices will rise. Inflation-induced increases in income are not likely to generate additional employment, to encourage savings, or to help lower the total
government budget deficit. Consequently, as the U.S. economy reaches
full capacity, policies of promoting a
dollar depreciation and of encouraging
faster growth abroad will not be sufficient to lower the current-account deficit. The United States will need other
measures to encourage private savings
relative to private investment and to
lower the government budget deficit.

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Federal Reserve Bank of Cleveland

April I, 1987

ECONOMIC
COMMENTARY
If the United States is to eliminate its external deficit, it must satisfy certain
basic economic conditions with respect
to its private savings, private investment, and total government budget
deficit.'
The U.S. current-account deficit
reached a record $140.6 billion in 1986
and probably will not improve, on balance, this year. A slight worsening early
in 1987 could offset a modest improvement late in the year. Consequently, the
United States will continue to amass
external debts and will become one of
the world's largest debtor countries.
The intense foreign competition evidenced by recent current-account deficits has slowed growth in U.S. tradedgoods industries and has heightened
protectionist sentiments to levels
unparalleled since the 1930s. Moreover,
the rapid rise in U.S. international
indebtedness challenges our ability to
sustain the rate of growth in our
standard of living that most of us have
come to expect.
The United States thus far has relied
primarily on a two-pronged approach to
alleviate the trade imbalance. Until
quite recently, we have promoted a
depreciation of the dollar in foreignexchange markets, hoping to restore the
competitiveness of U.S. goods. In addition, we are encouraging Japan and Germany to stimulate their economies in order to increase demand for U.S. exports.
This Economic Commentary examines whether these policies meet the
basic criteria required to eliminate our
external imbalance. We first develop a
framework to illustrate the nature of
current-account deficits and to describe
conditions for correcting a deficit. Next,
we compare U.S. policy against this
framework.
Owen F. Humpage is an economic adviser at the
Federal Reserve Bank of Cleveland.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Requirements for
Eliminating the
Trade Deficit
by Owen F. Humpage

Chart 1 The Current-Account Balance in a NationalIncome-Account Framework
CurrentAccount
Balance

Gross
Private
Savings

Gross
Private
Investment

Total
Government
Budget
Deficit

The Nature of a CurrentAccount Deficit
The national income and product
accounts provide an accounting framework for recording our gross national
product (GNP). The accounts show
that nominal GNP equals the realized
nominal values of private consumption,
plus private investment, plus government spending, plus exports, less
imports. One can adjust the accounts
and rearrange them to get an expression for the current-account deficit.
The current account records our
nation's international trade in goods
and services plus net transfers that
carry no obligation for repayment.
Rearranged, the accounting framework indicates that a nation's gross
private savings, less its gross private
investment, less its total government
(state, local, and federal) budget deficit
equal its current-account balance (see
chart 1). According to this expression, a
nation running a current-account
deficit is not saving sufficiently to
finance its private investment and total
government budget deficit. Similarly, a
nation running a current-account sur-

plus is saving more than is needed to
finance its private investment and total
government deficit.
In 1986, for example, private savings
in the United States totaled $681 billion; private investment equaled $686
billion; and the government budget
deficit amounted to $143 billion. With
private savings less than private
investment and the total government
budget deficit last year, the United
States experienced a $143 billion
current-account deficit.s The $5 billion
discrepancy in the arithmetic reflects
errors and omissions in our measurements of international transactions,
plus some other adjustments that typically are small in magnitude.'
Table 1 presents similar data for the
United States since 1980. To facilitate
comparisons over time, the data are expressed as percentages of GNP. The
table shows that the increase in the
U.S. current-account deficit since 1980
has been associated with an increase in
the total government budget deficit and,
since 1982, with a narrowing in private
savings relative to private investment.
The growth in the total government budget deficit reflects the huge federal

1. Most textbooks on international economics
present this argument; it stems from S.S. Alexander, "Effects of Devaluation on a Trade Balance," International Monetary Fund Staff Papers,
vol. 2 (April 1952), pp. 263-78. See also Economic
Report of the President, U.S. Government Printing
Office, Washington, D.C., transmitted to the
Congress January 1987, Chapter 3.

2. These are preliminary data; complete final
data for 1986 are not yet available.
3. In the actual measurement of the accounting
framework, the U.S. Department of Commerce
sets gross private savings, less gross private
investment, less the total government budget
deficit equal to "net foreign investment." Net for-

There is nothing intrinsically wrong
with a nation being a debtor, but debtor
status raises two concerns. The first
(Percent of GNP)
has to do with the willingness of forCurrentTotal
Savings
Gross
Gross
Less
Account
Government
eigners to hold dollar-denominated
Private
Private
Deficit
Balance"
Investment
Savings
Investment
assets. International investors, at some
point, could become increasingly reluc1.5%
-1.3%
0.5%
1980
17.5%
16.0%
tant to hold dollar-denominated assets
-1.0
0.3
2.9
1981
18.0
16.9
in their portfolios, and might shift
0.0
-3.6
1982
18.3
14.7
3.6
rapidly out of those assets. This reluc-1.0
17.4
-3.8
2.7
tance could stem from an acceleration
1983
14.7
-2.4
in inflation or from a slowdown in the
-2.7
1984
0.3
17.9
17.6
U.S. economy relative to other coun-3.4
16.5
-2.9
0.7
1985
17.2
tries, and could result in higher real
-3.4
-3.4
-0.1
1986b
16.2
16.3
interest rates in the United States and
a rapid depreciation of the dollar. At
a. We measure the current-account balance by net foreign investment (see footnote 3 in text).
present, foreign investors do not seem
b. Preliminary data.
saturated with dollar-denominated
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. Data are found in Ecoassets, nor are they rapidly attempting
nomic Report of the President, January 1987, table B-27.
to diversify out of dollar assets.
A second concern about the debt has
budget deficit, since state and local
to do with servicing it. In the future,
account surplus, on balance, in the rest
governments typically run surpluses.
the United States will need to pay a
of the world. According to the accountportion of its income to foreigners to
In general, a current-account deficit
ing framework, the rest of the world
reflects a decision to consume, both
meet obligations associated with our
must be saving more, on balance, than
privately and publicly, and to invest
international debt. This will represent
is necessary to finance its private
more than we currently are producing.
a transfer of real resources that will no
investments and any government
The purpose of table 1 is not to speclonger be available for domestic conbudget deficits.
ify a channel of causation, but simply
. sumption. Consequently, the debt can
The United States finances its
to show a tautological relationship
have important implications for lowered
current-account deficit by reducing
among private savings, private investgrowth in our standard of living.
claims on foreigners and by selling
ment, the government budget deficit,
The relationship between external
assets to foreigners.' These assets
and the current-account balance.
debt and the standard of living depends
include stocks, bonds, bank accounts,
Nevertheless, the important implicaon how the debtor country uses foreign
and physical property in the United
tion is that steps taken to correct the
savings. When a country borrows to
States. As foreigners buy these assets,
current-account deficit also must
finance private or public investments
they channel their savings into the
change private savings, private
in new capital, the additional investUnited States and help to finance U.S.
investment, the government budget
ments tend to generate a stream of
private investment and the government
deficit, or all three. Policies or events
income growth that helps to service the
budget deficit at interest rates lower
that fail to affect both sides of the reladebt. A nation can borrow, invest the
than otherwise would prevail. Worldtionship permanently will not alter the
funds, repay the debts, and generate
wide, these savings flows respond to
current-account deficit.
faster growth in its standard of living.
various economic variables, particuA problem arises when a nation borlarly interest rates and exchange rates,
rows to finance consumption rather
which adjust continually to balance
than investment. Then, future income
supplies of, and demands for, credit.
Financing the Current-Account
growth is not enhanced and, as future
A country that constantly runs a
Deficit
income is diverted from domestic concurrent-account deficit eventually will
As previously explained, our currentsumption to service foreign debts,
become a debtor nation, with obligations
account deficit reflects a situation in
growth in the domestic standard of livto foreigners exceeding its claims on
which society saves less than is necesing slows. Some economists worry that,
foreigners. The United States had been
sary to finance its private investment
because the current-account deficit is
a creditor nation since the early part of
and government deficit. One can
primarily associated with a rise in the
the twentieth century. Our net investunderstand better the nature of the
government budget deficit, the need to
ment position reached $141 billion in
current-account deficit and our concern
finance our international debts will
1981, but subsequently deteriorated
about its persistence by considering
result in a reduction in the growth of
because of our current-account deficits.
how we finance our deficits.
our standard of living.
The necessary counterpart to the U.S. By the end of 1985, the United States
had amassed $107 billion in external
current-account deficit is a currentdebt. Final data for 1986 probably will
show an external debt of $250 billion.

Some Magnitudes
The following scenarios attempt to
illustrate possible magnitudes of U.S.
international indebtedness. We do not
intend them as forecasts of likely outcomes, but rather as a simulation of
conceivable dimensions under reasonable assumptions about long-run average
nominal GNP growth and long-run
average nominal interest rates.
Most economists believe that the trade
deficit will begin a period of continuous
improvement in late 1987. Nevertheless, even as we unwind our trade
deficit, our net international indebtedness could easily double or triple from
its 1986 level. Assume, for example, a
$20 billion per year improvement in our
trade deficit; assume an annual 6.5 percent nominal GNP growth; and assume
an interest rate of 6.0 percent on outstanding debts." In this case, the trade
deficit could disappear in 1995, but our
net indebtedness could continue to
grow through 1999 because of the
interest due on our outstanding debts.
In this scenario, our international debt
could reach nearly $1.4 trillion by late
in the next decade.
Under these assumptions, interest
payments to foreigners could rise to
approximately 1 percent of GNP by
1994 and could remain near that level
until 1997. Over these years, therefore,
we could divert approximately 1 percent of our total national output to foreigners. This represents a payment for
the privilege of presently consuming
and investing more resources than we
are producing. While 1 percent of GNP
does not seem to be a large amount, it
represents a significant departure from
past trends, and it implies a smaller
share of GNP available for domestic
consumption and investment.
Of course, many things could alter
our scenario. For example, higher
interest rates or a failure to cut the
trade deficit could aggravate U.S.
international indebtedness. On the
other hand, lower interest rates or a
faster reduction in the trade deficit
could reduce the future burden of
interest payments. With an annual $40
billion improvement in the trade balance, the trade deficit could disappear
by 1992. Interest payments to foreigners might remain below 0.8 percent of

4. Because of difficulties in measuring international transactions, the current-account balance
typically differs from the net transactions that
channel foreign savings into the United States
and that help finance the current-account deficit
by an errors-and-omissions component.

5. One can think of these assumptions as
embodying a 3.0 to 3.5 percent average rate of
inflation, a 2.5 to 3.0 percent average rate of real
economic growth, and a 2.5 to 3.0 percent average
real interest rate. We do not assume an acceleration in real long-term growth.

Table 1 National Income Accounts and the Current-Account

Deficit

l

eign investment is equal to the current-account
balance, plus interest paid by the government,
plus capital grants, plus errors and omissions.
We ignore the usually small difference between
net foreign investment and the current-account
balance because we do not wish to add another
degree of difficulty to the exposition. This alters
none of our arguments.

GNP and quickly fall. The United
States could achieve creditor status
again in the late 1990s. This scenario
implies, however, that the current
account eventually shows a surplus of
3.4 percent of GNP, a ratio quite large
in a historical perspective.
Policy and the Deficit
Concerned about the magnitude of our
external balance, about the future implications of our indebtedness, and about
the growing tide of protectionism, U.S.
authorities, in accord with the Plaza
agreement of September 1985, promoted a depreciation of the dollar and
continue to encourage]apan and Germany to stimulate their economies.
However, the accounting framework indicates that if a country wishes to eliminate its current-account deficit, it
must adopt policies to increase its private savings relative to its private
investment and must reduce its government budget deficit.
The accounting framework does not
deny that promoting a currency depreciation or encouraging growth abroad
cannot speed or improve the adjustment process. Nor does the accounting
framework deny that a currency depreciation and faster growth abroad might
not be a necessary part of any adjustment process. The accounting framework, however, indicates that currency
depreciation and growth abroad are not
enough in themselves to eliminate the
current-account deficit. They may be
necessary, but they are not sufficient
for adjustment.
Consider, for example, an attempt by
the United States to foster a dollar depreciation. Attempts to induce a sustained depreciation of a currency generally require a nation to increase its
rate of money growth relative to that of
its trading partners." Indeed, since 1985
money growth in the United States has
increased and interest rates have fallen
relative to most foreign countries. While
most economists agree that a change in
the money growth rate can have a profound impact on exchange rates, the
links between money and the trade balance are weak at best. Consequently,
we should not be sanguine about our

6. We assume that money demand is stable in
the following example.

ability to engineer a lasting improvement in the trade balance solely
through a depreciation of the dollar.
Most economists would agree that a
permanent, unanticipated increase in a
nation's money growth rate will reduce
interest rates, at least temporarily, on
short-term money-market instruments.
Assuming that foreign money growth
and interest rates remain constant, the
reduction in U.S. interest rates could
induce international investors to shift
funds out of dollar-denominated assets
and into foreign-currency-denominated
assets. This shift will cause the dollar
to depreciate. Nominal exchange rates
(foreign currency units per dollar) as
well as real exchange rates would fall,
at least temporarily.
Nominal exchange rates are the rates
typically quoted in financial transactions, while real exchange rates are
equal to nominal exchange rates plus
an adjustment for inflation differentials
among the United States and its major
trading partners. Because real
exchange rates take into account both
exchange-rate movements and relative
price movements, the real exchange
rates determine trade flows.
A depreciation of real exchange rates
will improve the U.S. current-account
deficit by raising the dollar price of foreign goods and lowering the foreigncurrency price of U.S. goods. This development, however, will be temporary.
The faster pace of money growth in
the United States will induce other
effects that ultimately will offset the
dollar's real depreciation. If faster
money growth lowers real interest
rates (interest rates adjusted for inflation), it could encourage consumption
and investment while discouraging savings. As the accounting framework
illustrates, these developments will
tend to offset any initial improvement
in the trade balance.
More important, however, a faster
rate of money growth in the United
States eventually will translate into a
faster rate of inflation. Higher inflation
in the United States would make our
goods less competitive worldwide despite a nominal depreciation of the dollar. In other words, the faster pace of
inflation will reverse the real depreciation of the dollar, eliminating chances
for an improvement in trade.

There is nothing intrinsically wrong
with a nation being a debtor, but debtor
status raises two concerns. The first
(Percent of GNP)
has to do with the willingness of forCurrentTotal
Savings
Gross
Gross
Less
Account
Government
eigners to hold dollar-denominated
Private
Private
Deficit
Balance"
Investment
Savings
Investment
assets. International investors, at some
point, could become increasingly reluc1.5%
-1.3%
0.5%
1980
17.5%
16.0%
tant to hold dollar-denominated assets
-1.0
0.3
2.9
1981
18.0
16.9
in their portfolios, and might shift
0.0
-3.6
1982
18.3
14.7
3.6
rapidly out of those assets. This reluc-1.0
17.4
-3.8
2.7
tance could stem from an acceleration
1983
14.7
-2.4
in inflation or from a slowdown in the
-2.7
1984
0.3
17.9
17.6
U.S. economy relative to other coun-3.4
16.5
-2.9
0.7
1985
17.2
tries, and could result in higher real
-3.4
-3.4
-0.1
1986b
16.2
16.3
interest rates in the United States and
a rapid depreciation of the dollar. At
a. We measure the current-account balance by net foreign investment (see footnote 3 in text).
present, foreign investors do not seem
b. Preliminary data.
saturated with dollar-denominated
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. Data are found in Ecoassets, nor are they rapidly attempting
nomic Report of the President, January 1987, table B-27.
to diversify out of dollar assets.
A second concern about the debt has
budget deficit, since state and local
to do with servicing it. In the future,
account surplus, on balance, in the rest
governments typically run surpluses.
the United States will need to pay a
of the world. According to the accountportion of its income to foreigners to
In general, a current-account deficit
ing framework, the rest of the world
reflects a decision to consume, both
meet obligations associated with our
must be saving more, on balance, than
privately and publicly, and to invest
international debt. This will represent
is necessary to finance its private
more than we currently are producing.
a transfer of real resources that will no
investments and any government
The purpose of table 1 is not to speclonger be available for domestic conbudget deficits.
ify a channel of causation, but simply
. sumption. Consequently, the debt can
The United States finances its
to show a tautological relationship
have important implications for lowered
current-account deficit by reducing
among private savings, private investgrowth in our standard of living.
claims on foreigners and by selling
ment, the government budget deficit,
The relationship between external
assets to foreigners.' These assets
and the current-account balance.
debt and the standard of living depends
include stocks, bonds, bank accounts,
Nevertheless, the important implicaon how the debtor country uses foreign
and physical property in the United
tion is that steps taken to correct the
savings. When a country borrows to
States. As foreigners buy these assets,
current-account deficit also must
finance private or public investments
they channel their savings into the
change private savings, private
in new capital, the additional investUnited States and help to finance U.S.
investment, the government budget
ments tend to generate a stream of
private investment and the government
deficit, or all three. Policies or events
income growth that helps to service the
budget deficit at interest rates lower
that fail to affect both sides of the reladebt. A nation can borrow, invest the
than otherwise would prevail. Worldtionship permanently will not alter the
funds, repay the debts, and generate
wide, these savings flows respond to
current-account deficit.
faster growth in its standard of living.
various economic variables, particuA problem arises when a nation borlarly interest rates and exchange rates,
rows to finance consumption rather
which adjust continually to balance
than investment. Then, future income
supplies of, and demands for, credit.
Financing the Current-Account
growth is not enhanced and, as future
A country that constantly runs a
Deficit
income is diverted from domestic concurrent-account deficit eventually will
As previously explained, our currentsumption to service foreign debts,
become a debtor nation, with obligations
account deficit reflects a situation in
growth in the domestic standard of livto foreigners exceeding its claims on
which society saves less than is necesing slows. Some economists worry that,
foreigners. The United States had been
sary to finance its private investment
because the current-account deficit is
a creditor nation since the early part of
and government deficit. One can
primarily associated with a rise in the
the twentieth century. Our net investunderstand better the nature of the
government budget deficit, the need to
ment position reached $141 billion in
current-account deficit and our concern
finance our international debts will
1981, but subsequently deteriorated
about its persistence by considering
result in a reduction in the growth of
because of our current-account deficits.
how we finance our deficits.
our standard of living.
The necessary counterpart to the U.S. By the end of 1985, the United States
had amassed $107 billion in external
current-account deficit is a currentdebt. Final data for 1986 probably will
show an external debt of $250 billion.

Some Magnitudes
The following scenarios attempt to
illustrate possible magnitudes of U.S.
international indebtedness. We do not
intend them as forecasts of likely outcomes, but rather as a simulation of
conceivable dimensions under reasonable assumptions about long-run average
nominal GNP growth and long-run
average nominal interest rates.
Most economists believe that the trade
deficit will begin a period of continuous
improvement in late 1987. Nevertheless, even as we unwind our trade
deficit, our net international indebtedness could easily double or triple from
its 1986 level. Assume, for example, a
$20 billion per year improvement in our
trade deficit; assume an annual 6.5 percent nominal GNP growth; and assume
an interest rate of 6.0 percent on outstanding debts." In this case, the trade
deficit could disappear in 1995, but our
net indebtedness could continue to
grow through 1999 because of the
interest due on our outstanding debts.
In this scenario, our international debt
could reach nearly $1.4 trillion by late
in the next decade.
Under these assumptions, interest
payments to foreigners could rise to
approximately 1 percent of GNP by
1994 and could remain near that level
until 1997. Over these years, therefore,
we could divert approximately 1 percent of our total national output to foreigners. This represents a payment for
the privilege of presently consuming
and investing more resources than we
are producing. While 1 percent of GNP
does not seem to be a large amount, it
represents a significant departure from
past trends, and it implies a smaller
share of GNP available for domestic
consumption and investment.
Of course, many things could alter
our scenario. For example, higher
interest rates or a failure to cut the
trade deficit could aggravate U.S.
international indebtedness. On the
other hand, lower interest rates or a
faster reduction in the trade deficit
could reduce the future burden of
interest payments. With an annual $40
billion improvement in the trade balance, the trade deficit could disappear
by 1992. Interest payments to foreigners might remain below 0.8 percent of

4. Because of difficulties in measuring international transactions, the current-account balance
typically differs from the net transactions that
channel foreign savings into the United States
and that help finance the current-account deficit
by an errors-and-omissions component.

5. One can think of these assumptions as
embodying a 3.0 to 3.5 percent average rate of
inflation, a 2.5 to 3.0 percent average rate of real
economic growth, and a 2.5 to 3.0 percent average
real interest rate. We do not assume an acceleration in real long-term growth.

Table 1 National Income Accounts and the Current-Account

Deficit

l

eign investment is equal to the current-account
balance, plus interest paid by the government,
plus capital grants, plus errors and omissions.
We ignore the usually small difference between
net foreign investment and the current-account
balance because we do not wish to add another
degree of difficulty to the exposition. This alters
none of our arguments.

GNP and quickly fall. The United
States could achieve creditor status
again in the late 1990s. This scenario
implies, however, that the current
account eventually shows a surplus of
3.4 percent of GNP, a ratio quite large
in a historical perspective.
Policy and the Deficit
Concerned about the magnitude of our
external balance, about the future implications of our indebtedness, and about
the growing tide of protectionism, U.S.
authorities, in accord with the Plaza
agreement of September 1985, promoted a depreciation of the dollar and
continue to encourage]apan and Germany to stimulate their economies.
However, the accounting framework indicates that if a country wishes to eliminate its current-account deficit, it
must adopt policies to increase its private savings relative to its private
investment and must reduce its government budget deficit.
The accounting framework does not
deny that promoting a currency depreciation or encouraging growth abroad
cannot speed or improve the adjustment process. Nor does the accounting
framework deny that a currency depreciation and faster growth abroad might
not be a necessary part of any adjustment process. The accounting framework, however, indicates that currency
depreciation and growth abroad are not
enough in themselves to eliminate the
current-account deficit. They may be
necessary, but they are not sufficient
for adjustment.
Consider, for example, an attempt by
the United States to foster a dollar depreciation. Attempts to induce a sustained depreciation of a currency generally require a nation to increase its
rate of money growth relative to that of
its trading partners." Indeed, since 1985
money growth in the United States has
increased and interest rates have fallen
relative to most foreign countries. While
most economists agree that a change in
the money growth rate can have a profound impact on exchange rates, the
links between money and the trade balance are weak at best. Consequently,
we should not be sanguine about our

6. We assume that money demand is stable in
the following example.

ability to engineer a lasting improvement in the trade balance solely
through a depreciation of the dollar.
Most economists would agree that a
permanent, unanticipated increase in a
nation's money growth rate will reduce
interest rates, at least temporarily, on
short-term money-market instruments.
Assuming that foreign money growth
and interest rates remain constant, the
reduction in U.S. interest rates could
induce international investors to shift
funds out of dollar-denominated assets
and into foreign-currency-denominated
assets. This shift will cause the dollar
to depreciate. Nominal exchange rates
(foreign currency units per dollar) as
well as real exchange rates would fall,
at least temporarily.
Nominal exchange rates are the rates
typically quoted in financial transactions, while real exchange rates are
equal to nominal exchange rates plus
an adjustment for inflation differentials
among the United States and its major
trading partners. Because real
exchange rates take into account both
exchange-rate movements and relative
price movements, the real exchange
rates determine trade flows.
A depreciation of real exchange rates
will improve the U.S. current-account
deficit by raising the dollar price of foreign goods and lowering the foreigncurrency price of U.S. goods. This development, however, will be temporary.
The faster pace of money growth in
the United States will induce other
effects that ultimately will offset the
dollar's real depreciation. If faster
money growth lowers real interest
rates (interest rates adjusted for inflation), it could encourage consumption
and investment while discouraging savings. As the accounting framework
illustrates, these developments will
tend to offset any initial improvement
in the trade balance.
More important, however, a faster
rate of money growth in the United
States eventually will translate into a
faster rate of inflation. Higher inflation
in the United States would make our
goods less competitive worldwide despite a nominal depreciation of the dollar. In other words, the faster pace of
inflation will reverse the real depreciation of the dollar, eliminating chances
for an improvement in trade.

The speed at which faster money
growth translates into higher inflation
depends on expectations and on the
amount of slack in the economy. When
inflation expectations are widespread
or when little capacity is available to
accommodate foreign demand through
increased output, faster money growth
translates quickly into higher prices.
Under such conditions, faster money
growth might not result in even a transitory improvement in the trade balance.
Similar comments apply to the policy
of encouraging growth in Japan and
Germany. Such policies seek to increase
demand for U.S. goods and services. If
the United States is operating below
full capacity, U.S. manufacturers can
satisfy the increased demand through
additional production. If the economy is
operating at full capacity, however,
prices in the United States will rise to
choke off the increase in demand. The
trade balance will not improve.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OR 44101

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Conclusion
Any near-term success from promoting
a dollar depreciation and encouraging
faster growth abroad will owe much to
the fact that the U.S. economy is not
operating at full capacity. With unused
resources, the increased demand for
U.S. goods can generate increased production, employment, and real income.
The higher income could generate savings and could help reduce the government budget deficit.
Economists, unfortunately, are not
adept at measuring capacity or at predicting when capacity constraints will
become binding. Although we do not expect that the United States soon will
experience capacity constraints, the
unemployment rate is reaching levels
that many economists associate with
"full" or noninflationary employment,
and many economic forecasts now expect inflation to accelerate, although
modestly.

Once the U.S. economy reaches full
capacity, resources will be unavailable
to satisfy foreign demand, and domestic
prices will rise. Inflation-induced increases in income are not likely to generate additional employment, to encourage savings, or to help lower the total
government budget deficit. Consequently, as the U.S. economy reaches
full capacity, policies of promoting a
dollar depreciation and of encouraging
faster growth abroad will not be sufficient to lower the current-account deficit. The United States will need other
measures to encourage private savings
relative to private investment and to
lower the government budget deficit.

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Federal Reserve Bank of Cleveland

April I, 1987

ECONOMIC
COMMENTARY
If the United States is to eliminate its external deficit, it must satisfy certain
basic economic conditions with respect
to its private savings, private investment, and total government budget
deficit.'
The U.S. current-account deficit
reached a record $140.6 billion in 1986
and probably will not improve, on balance, this year. A slight worsening early
in 1987 could offset a modest improvement late in the year. Consequently, the
United States will continue to amass
external debts and will become one of
the world's largest debtor countries.
The intense foreign competition evidenced by recent current-account deficits has slowed growth in U.S. tradedgoods industries and has heightened
protectionist sentiments to levels
unparalleled since the 1930s. Moreover,
the rapid rise in U.S. international
indebtedness challenges our ability to
sustain the rate of growth in our
standard of living that most of us have
come to expect.
The United States thus far has relied
primarily on a two-pronged approach to
alleviate the trade imbalance. Until
quite recently, we have promoted a
depreciation of the dollar in foreignexchange markets, hoping to restore the
competitiveness of U.S. goods. In addition, we are encouraging Japan and Germany to stimulate their economies in order to increase demand for U.S. exports.
This Economic Commentary examines whether these policies meet the
basic criteria required to eliminate our
external imbalance. We first develop a
framework to illustrate the nature of
current-account deficits and to describe
conditions for correcting a deficit. Next,
we compare U.S. policy against this
framework.
Owen F. Humpage is an economic adviser at the
Federal Reserve Bank of Cleveland.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Requirements for
Eliminating the
Trade Deficit
by Owen F. Humpage

Chart 1 The Current-Account Balance in a NationalIncome-Account Framework
CurrentAccount
Balance

Gross
Private
Savings

Gross
Private
Investment

Total
Government
Budget
Deficit

The Nature of a CurrentAccount Deficit
The national income and product
accounts provide an accounting framework for recording our gross national
product (GNP). The accounts show
that nominal GNP equals the realized
nominal values of private consumption,
plus private investment, plus government spending, plus exports, less
imports. One can adjust the accounts
and rearrange them to get an expression for the current-account deficit.
The current account records our
nation's international trade in goods
and services plus net transfers that
carry no obligation for repayment.
Rearranged, the accounting framework indicates that a nation's gross
private savings, less its gross private
investment, less its total government
(state, local, and federal) budget deficit
equal its current-account balance (see
chart 1). According to this expression, a
nation running a current-account
deficit is not saving sufficiently to
finance its private investment and total
government budget deficit. Similarly, a
nation running a current-account sur-

plus is saving more than is needed to
finance its private investment and total
government deficit.
In 1986, for example, private savings
in the United States totaled $681 billion; private investment equaled $686
billion; and the government budget
deficit amounted to $143 billion. With
private savings less than private
investment and the total government
budget deficit last year, the United
States experienced a $143 billion
current-account deficit.s The $5 billion
discrepancy in the arithmetic reflects
errors and omissions in our measurements of international transactions,
plus some other adjustments that typically are small in magnitude.'
Table 1 presents similar data for the
United States since 1980. To facilitate
comparisons over time, the data are expressed as percentages of GNP. The
table shows that the increase in the
U.S. current-account deficit since 1980
has been associated with an increase in
the total government budget deficit and,
since 1982, with a narrowing in private
savings relative to private investment.
The growth in the total government budget deficit reflects the huge federal

1. Most textbooks on international economics
present this argument; it stems from S.S. Alexander, "Effects of Devaluation on a Trade Balance," International Monetary Fund Staff Papers,
vol. 2 (April 1952), pp. 263-78. See also Economic
Report of the President, U.S. Government Printing
Office, Washington, D.C., transmitted to the
Congress January 1987, Chapter 3.

2. These are preliminary data; complete final
data for 1986 are not yet available.
3. In the actual measurement of the accounting
framework, the U.S. Department of Commerce
sets gross private savings, less gross private
investment, less the total government budget
deficit equal to "net foreign investment." Net for-