Sarbanes Oxley

“Effects of a widening trade deficit and the necessary government policy”

“Trade Gap Widens, Fuels Calls for Tougher Stance on China” WSJ, 4/13/05, A2.

The U.S. current account (trade deficit) hit a monthly high rising 4.3% in February to $61.04 billion. The increased deficit reflects the rising costs of imported oil and increased consumer demand for foreign goods. Imports rose by $2.58 billion from January to February as Exports remained constant.

The widening trade deficit over the past two years has economists concerned about the longevity of attracting foreign capital. This is especially true between China and the U.S. where the deficit has increased 50% from 2004, making it the largest deficit of any single country.

As a result, there is pressure from industry officials to consider stronger trade guidelines to correct for this widening deficit. The U.S. cites the fixed yuan-dollar exchange rate for keeping China’s currency relatively weak and therefore encouraging the consumption of Chinese goods in world markets.

The U.S. government is considering a 27.5% tariff on all Chinese products entering the U.S. if Beijing refuses to raise the value of their currency. This purpose of this tariff would be to offset China’s currency advantage, but critics argue it may increase the price of Chinese-made goods more than a currency adjustment.

To assess the validity the proposed policies for this scenario, we will analyze this issue using intermediate economic theory as a framework.

The current account is of great concern to U.S. policymakers as a long-run surplus or deficit may have undesirable effects on the national welfare. Large imbalances can also create political pressures for increased trade restrictions, as is the case in our study. Therefore, it is important to determine how monetary and fiscal policies will affect the current account with respect to output and the exchange rate. We can illustrate the relationship between the exchange rate, output, and the current account in terms of the AA-DD framework.

The XX curve shows the combinations of the exchange rate and output where the current account balance would be equal to some desired level (equilibrium). The XX schedule is upward sloping because, ceteris paribus, an increase in output encourages spending on imports and worsens the current account if it is not accompanied by currency depreciation. The point labeled A, is where the graph is in equilibrium and the economy is at full employment (Yf) with a given exchange rate, Eo. Points to the left of the XX schedule indicate a current account surplus, while points to the right indicate a current account deficit. The result of an increase in money supply is illustrated by point B, while a temporary fiscal expansion would result in point C. The DD-AA model assumes that a real appreciation in domestic currency immediately improves the CA, while a real appreciation causes the CA to worsen. A more realistic approach to this is illustrated via a J-curve. The J-curve is constructed under the assumption that a country’s current account worsens immediately after a real currency depreciation, and that there is some lag before it improves months later. The following illustration shows a more realistic response to the current account.