Balance of Trade: Definition, Formula, and Types

Balance of Trade has been widely used as a variable when calculating the economic status of a country. However, this variable is still contentious due to the unclear comparisons of the implications of the different balance of trade forms.

Definition

Balance of trade is easily defined as the status of a country’s trade value with other countries. It is defined as the comparison between a country’s exports and imports. When the country’s exports are more than its imports, that BOT is considered positive. Negative BOT is when the country’s imports are more than its exports. As per this variable, a country that has a positive balance of trade is considered economically sound, while a negative balance of trade implies a struggling economy. Balance of trade is also called net exports, meaning exports minus imports.

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Balance of Trade Formula

Balance of trade is calculated by subtracting a country’s total imports from its exports as shown in the formula below:

Balance of Trade (Net Exports) = Total Exports – Total Imports

Balance of Trade (BOT) Vs Balance of Payments (BOP)

Balance of Trade is one of the variables under the greater Balance of Payments umbrella. BOP measures the net payments a country makes in other countries in the three forms: Current, Capital, and Financial Accounts.

Current Account encompasses now the balance of trade, that is the cash inflows from goods exported versus the cash outflows for the goods imported.
Capital Account includes all the asset inflows balanced with the outflows as a result of the possession, sale, and transfer of assets in and out of the country. Fixed assets such as land, mines, and buildings are literally not transferable from one country to another. However, the ownership to these assets may change severally, and these transfers are what’s used to calculate BOP’s capital account. This means that a country with more ownership of assets overseas has a positive capital account and hence favorable balance of payment. Capital account does not include financial assets as they are the basis of the financial balance of payment account.
Financial Account is the balancing of the transfer of financial assets in and out of the country. Financial assets, unlike fixed assets, are transferrable in the literal form, transfers which make up BOP financial account. The financial account includes all forms of financial assets and government securities transferred from one country to another.

Balance of payment is a major element of a country’s Gross Domestic Product mainly due to its composite form.

Types of Balance of Trade

There are three forms of BOT as per the above formula. A country can either have a positive BOT, negative one, or the exports equals imports. Therefore, the three types of balance of trade are Favorable, Unfavorable, and Equilibrium BOT.

1. Favorable Balance of Trade

A favorable balance of trade is the goal of every economy. Favorable BOT can generally imply that a country’s exports are higher than imports, and thus there is more money coming in than going out. In more detailed macroeconomic terms, favorable BOT may have the following implications:

Implications of Favorable BOT

The country has a trade surplus, as it’s exporting more and importing less
More foreign cash flows into the country
The country is saving more than it is spending
High productivity in the country
Less consumption in the country
The country’s government is spending more
The country has less investments in foreign countries

Favorable balance of trade may also be as a result of low-productivity in the country, as raw materials exported to other countries are also counted as exports. Favorable balance of trade has impacts across many aspects of the economy, such as employment, productivity, economic growth, foreign exchange rates, and the country’s budget size. The impacts, interestingly, are both positive and negative.

Impacts of Favorable BOT

Increased employment, as the country is producing more goods and services for export.
High inflation, as the country has more money supply from cash inflows.
High commodity prices. Exports have an unfavorable implication on consumers, in that there is less price competition in the country and more demand for goods produced.
A stronger currency. Exchange rates fluctuate according to currency demands. More exports create demand for the country’s currency, as importers will have to use the currency to pay for the goods sold.
A bigger budget. To sustain the demand for its currencies and high productivity, the country may make more government spending.
A greater GDP due to high productivity experienced in the country, and positive foreign exchange.

The other type of balance of trade is unfavorable BOT, which is the exact opposite of favorable BOT in all its good and bad dimensions.

2. Unfavorable BOT

Every country works to avoid this economic status, even though some power houses like the US and Hong Kong have hugely unfavorable balance of trade. From the BOT formula, unfavorable balance of trade is negative net exports, meaning the country is importing more and exporting less.

Implications of Unfavorable BOT

The country has a trade deficit, as the amounts of imports is more than exports
More consumption
The country is producing less
More investments made in foreign countries by the country
Less foreign investments into the country
The country is spending more and saving/investing less

These implications turn out to be negative, but that is not the case with the effects of a negative balance of trade. BOT is multi-dimensional and should be interpreted in all these dimensions.

Impacts of Unfavorable BOT

The country lurks in high unemployment conditions as production is low within
The country’s currency is set to depreciate in value due to reduced demand
Commodity prices will drop due to the price competition rendered by high amounts of goods imported in to the country
Higher living standards in the country due to high spending on the goods imported.
Lower inflation rates will be experienced over time, as the country will be flowing more cash in the outside compared to the money pumped in by foreign trade.
A tighter budget, as the country will want to spend less in order to appreciate the country’s currency.

When the pendulum settles in neither the favorable nor unfavorable balance of trade, it means there is a balance of trade.

3. Equilibrium Balance of Trade

This is the ideal situation for international trade. In as much as economies seek to increase net exchange, equilibrium balance of trade is what’s sought by international trading arrangements; to import as much as you export, and build each other in the trading arrangement. The implications of equilibrium BOT are a balance of foreign exchange, and the impacts are neither positive nor negative.

Balance of Trade sells good in politics, but as we see, it has its pros and cons. A country’s populi may rejoice in high trade surpluses, not knowing its implications on consumer prices and the living standards.

The bottom line: Balance of Trade is not a stand-alone measurement of economic health, and relies on other variables in the Balance of Payments umbrella.

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