June 24, 2019

Under a floating exchange rate system, equilibrium requires that the capital flows finance the sum of the budget deficit plus the private sector net borrowings. Hence in deciding as to whether a trade deficit is bullish or bearish for an economy one has to simultaneously reach the same conclusion about the capital flows. Consider two different shocks. One being an increase in the supply of goods and services, i.e. an excess supply shock, and the other being a reduction in the demand for goods and services, i.e. an excess demand shock. Both disturbances result in an improvement in the trade balance, but they have vastly different implications for the economy.

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