It may seem odd, but governments often step in to restrict trade. Why might a government want to restrict trade? If domestic industries cannot compete against foreign industries, the government will restrict trade to help the domestic industries develop. Governments may also restrict trade to foster business at home rather than encouraging business to move out of the country. These protectionist policies encourage prices to stay high and help domestic industries to develop.
Governments three primary means to restrict trade: quota systems; tariffs; and subsidies.
A quota system imposes restrictions on the specific number of goods imported into a country. Quota systems allow governments to control the quantity of imports to help protect domestic industries.
Tariffs are fees paid on imported goods. Tariffs increase the price that consumers pay for the good, thus reducing the quantity of the good demanded and making the price more in line with the price charged by domestic producers. Tariff profits may go to the government or to developing industries.
Subsidies are grants given to domestic industries to help them develop and compete with foreign producers. Through subsidies, domestic producers can charge less for their goods without losing money due to outside grants.
Through judicious use of quotas, tariffs, and subsidies, governments are able to improve the domestic economy. This may increase the price that domestic consumers pay for goods, though this small annoyance is usually outweighed by significantly bolstered overall economic levels and long-term economic growth.
In the section on net exports we learned that net exports equal exports minus imports. The difference between exports and imports is referred to as the trade deficit or the trade surplus. When exports exceed imports, a trade surplus exists. When imports exceed exports, a trade deficit exists.
There often talk about the effects of the trade deficit on the economy. What is the actual effect of the trade deficit though? Remember that when there is a trade deficit, net foreign investment fills the gap between exports and imports, as NX = NFI. Thus, if a large trade deficit exists, foreign investment must be high. This is slightly problematic as domestic companies often enjoy domestic ownership--a large trade deficit threatens this condition. A trade deficit is often matched with a large governmental budget deficit. Though the specific effects of a trade deficit are nebulous, in general a large trade deficit is thought to stunt long-term economic growth slightly.
How can the trade deficit be resolved? First, exports can be increased to make annual net exports positive. When employed, this method will cause a trade deficit decrease over time. Second, funds can be used to pay off foreign investors, reducing balance due from trade and causing a lower trade deficit.