“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.

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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.
The lagging response of the current account to fluctuations in the exchange rate makes it difficult to analyze the exact causes of the widening current account. However, there are several economic factors that we know are responsible for this increasing deficit with China.
In an effort to help bring the economy out of a recession in recent years the U.S. has been increasing the money supply by lowering interest rates. As a result people have been spending more money and consuming more. This increase in consumption has sparked increased demand for imports and consequently the U.S. has been spending more on imports especially with Chinese-made products. This would not be a real big problem if the U.S. had also been able to increase their exports; however exports remained relatively constant while imports continued to grow.
With concerns of inflation now plaguing the U.S., the Fed has decided to increase the pace at which they increase interest rates. This action is necessary to control for runaway inflation and attempts to reduce the money supply. The result of this action is an appreciation of the dollar exchange rate. The following illustration shows the relationship.


The resulting effects of the appreciated dollar and therefore the price of foreign goods being cheaper makes the current account balance even more likely to have a deficit since foreign goods will be cheaper than domestic goods in some instances.
The proposed tariff on imported goods, more specifically a 27.5% tariff on Chinese-made goods will attempt to make the consumer indifferent between foreign and domestic goods as the prices of the two goods will be more similar. This will cause the current account to head back towards equilibrium. In order for the current account to reach a condition more like point A in Illustration 1, China will have to appreciate their currency. There are several ways which China could try to appreciate their currency, but the most likely would be to lower interest rates and thereby increase their money supply. By doing so they would be able to appreciate their currency and avoid the U.S. imposing a 27.5% tariff on all Chinese goods which may have undesirable long-term effects and may also negatively effect U.S.-China relations.