Discuss whether efforts by the government to correct a sustained trade deficit could be damaging to the economy.
For years, there has been growing concern over the large and persistent trade imbalances between countries in the global economy. This issue gained particular prominence during Donald Trump’s presidency, when the United States—facing a substantial and long-running trade deficit—took a more protectionist stance. Trump pushed for what he described as “fair trade,” implementing tariffs and renegotiating trade agreements in an effort to reduce imports and bring about what many referred to as “global rebalancing.” His administration argued that cutting the trade deficit was essential to strengthening the U.S. economy and correcting perceived imbalances in global trade relationships.
b. Discuss whether efforts by the government to correct a sustained trade deficit could be damaging to the economy. [15]
Introduction
A trade deficit, or balance of trade (BOT) deficit, arises when a country’s import expenditure exceeds its export revenue. While not inherently harmful in the short run—especially if it reflects strong domestic demand or capital investment—a sustained trade deficit can signal structural issues such as a lack of competitiveness or overreliance on imports. In response, governments may attempt to correct trade imbalances using policy tools like protectionism or currency devaluation. However, while these measures may improve the trade balance in theory, they can also have adverse consequences for both the domestic and global economy.
How Protectionism Might Reduce the Trade Deficit
One common government response is to impose protectionist policies, such as tariffs on imported goods. By increasing the price of imports, tariffs can make foreign goods less attractive to domestic consumers, thus reducing import expenditure.
For example, if the U.S. imposes a 25% tariff on Chinese electronics, American consumers might switch to locally produced alternatives, or simply consume less. This reduction in M (imports) improves the (X – M) component of Aggregate Demand (AD), narrowing the BOT deficit.
This was precisely the logic behind President Trump’s imposition of tariffs on goods from China and renegotiation of trade agreements like NAFTA into the USMCA, with the goal of stimulating domestic industry and achieving “fairer” trade outcomes.
However, protectionist measures come with significant economic risks.
Retaliation and Trade Wars: Other countries may retaliate with their own tariffs. For example, China responded to U.S. tariffs by targeting American agricultural products, hurting U.S. farmers. This tit-for-tat escalation reduces exports for both countries, potentially worsening—not improving—the BOT.
Higher Production Costs: Many domestic industries rely on imported inputs. Tariffs on raw materials (e.g. steel, semiconductors) raise input costs for producers, reducing competitiveness. In the U.S., automakers faced higher costs after steel tariffs were imposed, eroding profit margins and raising prices for consumers.
Global Recession Risks: Widespread adoption of protectionism leads to "beggar-thy-neighbour" policies, where one country’s gain comes at the expense of others. As global trade contracts, global GDP growth slows, leading to a net loss in global economic welfare. The 1930s Great Depression is often cited as a cautionary tale of where unchecked protectionism can lead.
How Currency Devaluation Might Help
Another tool to reduce a trade deficit is currency devaluation. A country’s central bank can sell domestic currency on the foreign exchange market, increasing its supply and causing its value to depreciate.
A weaker currency makes exports cheaper in foreign currency terms, while imports become more expensive in domestic currency terms. Assuming the Marshall-Lerner Condition is met (i.e. the sum of price elasticities of exports and imports is greater than one), this should lead to a rise in export volumes and a fall in import volumes, improving (X – M) and thus reducing the trade deficit.
Despite its appeal, devaluation also presents significant downsides, especially for import-dependent economies.
Imported Inflation: For countries that rely heavily on imported goods, such as Singapore, a weaker currency leads to higher prices for essentials like food, fuel, and pharmaceuticals. This raises the general price level (GPL) and reduces real purchasing power for households.
Cost-Push Inflation: If firms depend on imported raw materials or capital goods, devaluation increases their costs, leading to a leftward shift in Short-Run Aggregate Supply (SRAS). As production becomes more expensive, firms pass on higher costs to consumers, resulting in cost-push inflation. This undermines the intended benefits of devaluation and can lower real output.
Unstable Investment Climate: A deliberate weakening of the currency can also undermine investor confidence, especially if it appears politically motivated or unsustainable. Volatile exchange rates make it harder for firms to plan for the future and may deter foreign direct investment (FDI).
Conclusion
Efforts to correct a sustained trade deficit—whether through protectionist tariffs or currency devaluation—can deliver short-term improvements to a country’s trade balance. However, these policies also come with significant trade-offs. Protectionism risks retaliation, inefficiencies, and global recession, while devaluation can trigger inflation and weaken long-term competitiveness.
The effectiveness and consequences of such policies depend heavily on the structure of the economy. For example, protectionism may be more viable in large economies with diverse production like the U.S., but less so in open economies like Singapore. Devaluation may benefit economies with elastic export demand, but can be harmful to those reliant on imports for daily necessities.
Ultimately, instead of relying solely on these blunt instruments, governments should consider long-term strategies to correct trade deficits—such as investing in export competitiveness, encouraging innovation, and reducing structural inefficiencies
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