Explain the impact of a sustained trade deficit on an economy.
a. Explain the impact of a sustained trade deficit on an economy. [10]
Introduction
A balance of trade deficit arises when a country’s import expenditure exceeds its export revenue, meaning that more money is flowing out of the country to pay for foreign goods and services than is coming in from the sale of domestic goods and services abroad. This situation may occur due to a surge in domestic consumption of imported goods, a lack of export competitiveness, or structural weaknesses in the export sector. While a trade deficit is not necessarily harmful in the short term, a sustained trade deficit over a prolonged period may pose several risks and negative consequences to the macroeconomic stability and long-term performance of the economy.
Depreciation of the Domestic Currency
One immediate implication of a persistent trade deficit is pressure on the exchange rate of the domestic currency. A consistent outflow of foreign exchange to pay for imports increases the supply of the domestic currency in foreign exchange markets, while weak demand for exports reduces the demand for the domestic currency. As a result, the currency may depreciate over time.
A weaker currency can have both positive and negative effects. On one hand, it may improve export competitiveness, as the price of domestically produced goods becomes relatively cheaper for foreign buyers. This can help to increase export volumes and partially correct the trade deficit, provided the Marshall-Lerner condition is satisfied—that is, the sum of the price elasticities of demand for exports and imports is greater than one.
However, the downside is that depreciation makes imports more expensive in terms of the domestic currency. For countries that are highly dependent on imports—such as Singapore, which imports most of its food, fuel, and raw materials—this leads to imported inflation. As the prices of imported consumer goods and production inputs rise, this may reduce purchasing power for households and raise costs for businesses, leading to a higher general price level and a fall in the standard of living.
Decline in Foreign Exchange Reserves
A sustained trade deficit contributes to a worsening current account position, which can affect the overall balance of payments. To finance the ongoing deficit, a country may be forced to draw down on its foreign exchange reserves, which are held by the central bank to stabilise the currency and support international obligations.
A significant depletion of reserves reduces the central bank’s ability to manage exchange rate policy, particularly in economies that adopt a managed float or fixed exchange rate regime. For instance, the central bank may be less able to intervene in the foreign exchange market to prevent excessive volatility or protect the value of the currency. In times of crisis or sudden capital flight, limited reserves can undermine investor confidence, leading to further depreciation and financial instability.
Fall in Aggregate Demand and National Income
From an aggregate demand (AD) perspective, the trade balance is a component of AD, specifically through the term (X - M). A sustained trade deficit implies that (X - M) is negative and, if the deficit worsens over time, this could lead to a decline in AD. This is especially damaging during periods of weak investment and consumption, as the economy may become more reliant on net exports for growth.
A fall in AD leads to a leftward shift of the AD curve, resulting in lower real national income (NY) and slower economic growth. As firms experience declining sales, they may reduce hiring or cut jobs, leading to higher cyclical unemployment. Over time, if this persists, it may further erode consumer confidence and reduce household spending, exacerbating the downturn.
This is particularly concerning for economies where the export sector is a major driver of growth, such as Singapore or South Korea. A protracted decline in export earnings due to external factors—such as global downturns, protectionist measures, or loss of competitiveness—can severely undermine domestic economic performance.
Conclusion
In conclusion, while a trade deficit in itself is not inherently damaging, a sustained and widening trade deficit can have serious implications for an economy. It can place downward pressure on the currency, resulting in imported inflation, weaken the country's ability to conduct monetary and exchange rate policy due to a fall in foreign exchange reserves, and contribute to weaker aggregate demand, lower national income, and higher unemployment. Policymakers need to address the underlying causes of persistent trade deficits—such as low export competitiveness or over-reliance on imports—through structural reforms, productivity-enhancing measures, and trade diversification strategies to ensure long-term macroeconomic stability.
📚 Get Free A Level Economics & GP Resources — Straight to Your Phone
Found this essay useful? There’s plenty more where that came from — and it’s 100% free.
Join over 2,000 JC students on the ETG Telegram Channel and unlock instant access to high-quality A Level content — curated by Mr Eugene Toh, one of Singapore’s most trusted economics tutors.
🎁 Inside the Channel:
📘 Model Essays (Economics & GP)
📊 Summary Notes for quick revision
📉 Annotated Diagrams for application clarity
✍️ GP Templates, Examples & Essay Openers
💡 A Level Predictions, Study Tips & Smart Strategies
Whether you’re preparing for JC1 Promos or JC2 A Levels, this is your go-to revision companion — powered by Singapore’s leading economics tuition centre.
💡 No Sign-Up, No Spam — Just Value
You don’t have to be an ETG student to benefit.
This is our way of giving back to the wider JC community — because great economics tuition Singapore starts with sharing.
📲 Join the Channel Now → t.me/etgecons
📨 Forward the link to a friend. Save your favourite notes. Let’s ace this together 💪
Smart, stress-free revision begins here — and it fits in your pocket.