Question

3. Briefly explain how short-term movements in the business cycle affect the trade balance.

Answer 1

The balance of trade is the difference between a country's exports and imports and depicts a current acclunt balance.

In the short term, the trade balance can be affected by whether the business is in a recession or an upswing. A recession tends to make a trade deficit smaller, or trade surplus larger. This is because in a recession, consumer spending falls. Thus, spending on imports decreases. Moreover, as a result of an interest rate cut during a recession, there is a depreciation in the exchange rate making exports cheaper and imports expenaive, thus increasing exports.

On the other hand, an upswing created by a period of strong economic growth tends to make a trade deficit larger or trade surplus smaller. This occurs because people tend to import more when the economy is doing well (luxurious consumption) and higher interest rates lead to currency appreciation making exports costlier and thus an expected fall in exports.