Definition
The balance of trade forms part of the current account, which also includes other transactions such as income from the international investment position as well as international aid. If the current account is in surplus, the country's net international asset position increases correspondingly. Equally, a deficit decreases the net international asset position.
The trade balance is identical to the difference between a country's output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stocks, nor does it factor the concept of importing goods to produce for the domestic market).
Measuring the balance of payments can be problematic because of problems with recording and collecting data. As an illustration of this problem, when official data for all the world's countries are added up, exports exceed imports by a few percent; it appears the world is running a positive balance of trade with itself. This cannot be true, because all transactions involve an equal credit or debit in the account of each nation. The discrepancy is widely believed to be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. However, especially for developed countries, accuracy is likely to be good.
Factors that can affect the balance of trade figures include:
Prices of goods manufactured at home (influenced by the responsiveness of supply)
Exchange rates
Trade agreements or barriers
Other tax, tariff and trade measures
Business cycle at home or abroad.
The balance of trade is likely to differ across the business cycle. In export led growth (such as oil and early industrial goods), the balance of trade will improve during an economic expansion. However, with domestic demand led growth (as in the United States and Australia) the trade balance will worsen at the same stage in the business cycle.

Economic impact
Modern economists are split on the economic impact of the trade deficit with some viewing it as a loss in a fixed volume of trade and more radical Neoliberal voices who claim it is a sign of economic strength.
The traditional view opposes long run trade deficits and outsourcing for the sake of labor arbitrage to obtain cheap labor as an example of absolute advantage which does not produce mutual gain, and not an example of comparative advantage which does.[1][2][3]
Neoliberal economists claim that trade deficits are beneficial, noting the correlation between increasing trade deficits and increasing GDP and employment ([1]). An expanding economy means increased demand for domestic and foreign products. This rising demand promotes domestic investment as both foreign and domestic businesses seek to capitalize on the growth in demand. As the rate of growth accelerates foreign credit sources have greater incentives to invest in a growing nation's capital. The greater net inflows from abroad, the greater the trade deficit. Thus, GDP growth can be correlated with a trade deficit. However, these economists seem to ignore the fact the excessive borrowing may artificially inflate GDP.
Strong GDP growth economies such as the United Kingdom, Australia, Hong Kong and the United States run consistent trade deficits.
On the other hand, GDP growth may be due to excess borrowing to fund consumption and not an expansion of the base of an economy.[4] Developed nations such as Canada, Japan, and Germany typically run trade surpluses. China also has a trade surplus. A higher savings rate generally corresponds with a trade surplus. In 2006, the United States has its lowest savings rate since 1933.[5] Correspondingly, the United States has high trade deficits. The general decline of Great Britain is another example of the deleterious effects of long term trade deficits.
Some contend long term effects of the trade deficits are deleterious. Since the stagflation of the 1970's, the U.S. economy has been characterized by somewhat slower growth. In 1985, the U.S. began its growing trade deficit with China. In 2006, the primary economic concerns have centered around: high national debt ($9 trillion), high corporate debt ($9 trillion), high mortgage debt ($9 trillion), high unfunded Medicare liability ($30 trillion), high unfunded Social Security liability ($12 trillion), high external debt (amount owed to foreign lenders) and a serious deterioration in the United States net international investment position (NIIP) (-24% of GDP),[6] high trade deficits, and a rise in illegal immigration. These issues have raised concerns among economists and unfunded liabilites were mentioned as a serious problem facing the United States in the President's 2006 State of the Union address.[7]
Large imbalances may sometimes be a sign of underlying economic problems or rigidities. An example would be a situation where exchange rates have been fixed or pegged for political reasons at levels impeding a correction of a trade imbalance.
The trade deficit must be "financed" by foreign income or transfers, or by a capital account surplus. This includes inward foreign investment and capital purchases (stocks, bonds ect). An increase in net foreign liabilities tends to lead to an increase in the net outflow of income on international investments.
Those in favor of the trade deficit point to this financing as the source of the benefit. Instead of buying goods back, buyers in the receiving country send the money back in the form of capital. A firm in America sends dollars for Chinese toys, and the Chinese receivers use the money to buy stock in an American firm. Although this is a form of financing, it is not a debt on any party in America.
Such payments to foreigners have intergenerational effects: by shifting consumption over time, some generations may gain at the expense of others ([2]). However, a trade deficit may lead to higher consumption in the future if, for example, it is used to finance profitable domestic investment, which generates returns in excess of that paid on the net foreign liabilities (a situation that might arise if a country experiences an unexpected gain in productivity). Similarly, a surplus on the current account implies an increase in the net international investment position and the shifting of consumption to future rather than current generations.
However, trade imbalances are not always indicative of the smooth operation of the market given differences in international productivity and intertemporal consumption preferences. Trade deficits have often been associated with a loss of international competitiveness, or unsustainable 'booms' in domestic demand. Similarly, trade surpluses have been associated with policies that inefficiently bias a country's economic activity towards external demand, resulting in lower living standards. An example of an economy which has had a positive balance of payments was Japan in the 1990s. The positive balance was partly the result of protectionist measures that brought excessive profits to Japanese exporters.United States trade deficit
The United States has posted a trade deficit since the 1970s, and it has been rapidly increasing since 1997 (see chart below). The US trade deficit hit a record high of 763.6 billion dollars in 2006, up from 716.7 billion dollars in 2005.[3]
It is worth noting on the graph that the deficit slackened during recessions and grew during periods of expansion.



Milton Friedman on trade deficits

US exports in 2006
Milton Friedman, the Nobel Prize-winning economist and father of Monetarism, argued that many of the fears of trade deficits are unfair criticisms in an attempt to push macroeconomic policies favorable to exporting[4] industries. He stated that these deficits are not harmful to the country as the currency always comes back to the country of origin in some form or another (country A sells to country B, country B sells to country C who buys from country A, but the trade deficit only includes A and B). In fact, in his view, the "worst case scenario" of the currency never returning to the country of origin was actually the best possible outcome: the country actually purchased its goods by exchanging them for pieces of cheaply-made paper. As Friedman put it, this would be the same result as if the exporting country burned the dollars it earned, never returning it to market circulation.
Critics claim that Friedman's argument is equivalent to saying that it doesn't matter if you get indebted, because eventually you will have to pay the money back. The obvious counterargument is that once a significant debt has been accumulated, paying it back may be painful. Friedman's supporters retort that when the money returns, the demand for foreign currency will make the exchange rate better for trade deficit country.
Friedman's view is seen by many as ignoring the intergenerational or long run consequences of deficits, low savings, and borrowing to fund consumption. If country A has a trade deficit because of large imports of consumer goods, other countries accumulate cash from country A. That money can be used to purchase existing investment assets and government bonds within country A. As a result, the return from those assets will accrue not to citizens of country A but to foreigners. The consumption standard of future generations in country A may therefore potentially decline as a result of the deficit. In particular, Americans are increasingly paying taxes to finance the interest on federal bonds held by foreigners. However, a criticism of this argument notes that all transactions are win-win. In the case of foreign investment in American assets, it helps fuel American economic growth and keeps US interest rates low. This argument is more appealing in the case of foreign direct investment, and less obvious when foreigners simply purchase the existing stock of assets.
Friedman also believed that deficits would be corrected by free markets as floating currency rates rise or fall with time to encourage or discourage imports in favor of the exports, reversing again in favor of imports as the currency gains strength. A potential difficulty however is that currency markets in the real world are far from completely free, with government and central banks being major players, and this is unlikely to change within the foreseeable future.
Friedman and other economists have also pointed out that a large trade deficit (importation of goods) signals that the country's currency is strong and desirable. To Friedman, a trade deficit simply meant that consumers had opportunity to purchase and enjoy more goods at lower prices; conversely, a trade surplus implied that a country was exporting goods its own citizens did not get to consume or enjoy, while paying high prices for the goods they actually received.
Perhaps most significantly, Friedman contended strongly that the current structure of the balance of payments is misleading. In an interview with Charlie Rose, he stated that "on the books" the US is a net borrower of funds, using those funds to pay for goods and services. He pointed to the income receipts and payments showing that the US pays almost the same amount as it receives: thus, U.S. citizens are paying lower prices than foreigners for capital assets to exchange roughly the same amount of income. The reasons why the U.S. (and UK) appear to earn a higher rate of return on their foreign assets than they pay on their foreign liabilities are not clearly understood. An important contributing factor is that the U.S. has investment primarily in stocks abroad, while foreigners have invested heavily in debt instruments, such as U.S. government bonds ([5]). More recently, U.S. net foreign income has deteriorated, and appears set to stay in deficit in the future ([6]).
Friedman presented his analysis of the balance of trade in Free to Choose, widely considered his most significant popular work.

Physical balance of trade
Monetary balance of trade is different from physical balance of trade (which is expressed in amount of raw materials). Developed countries usually import a lot of primary raw materials from developing countries at low prices. Often, these materials are then converted into finished products, and a significant amount of value is added. Although for instance the EU (as well as many other developed countries) has a balanced monetary balance of trade, its physical trade balance (especially with developing countries) is negative, meaning that in terms of materials a lot more is imported than exported. This is part of an economic theory called dependency theory. If this theory is true, what would it mean for China and India's economic development?