A New Modeling Approach for Helping to Understand the Causes and Consequences of Trade Imbalances

President Trump’s tariffs have revitalized the debate about the causes and consequences of the US trade deficit. In this paper, we put forward a theoretical model that contributes to this discussion. In autarky, countries with low saving rates will have lower capital stock to GDP ratios and a higher marginal product of capital than countries with high saving rates; consequently, investment opportunities in the low saving rate countries will tend to offer higher returns. When such countries interact and when there are no financial market imperfections or barriers, our model predicts that a low saving rate country will initially have a trade deficit and that the high saving rate country will have a trade surplus as a way of transferring real capital to where its marginal product is higher. These transfers of capital will eventually cause rates of return on capital to converge and trade imbalances to decline and to eventually reverse themselves. However, because trade imbalances are small compared to capital stocks, this process may take many decades, as a result of which trade imbalances may persist for some time.