Question

Trade balance:

a) Is trade deficit always a bad thing? Explain you answer in details. Support your argument with an example.

b) Assume that government provides export subsidies to encourage the export of goods. Will this policy result into an improved trade balance in the long run? Why? Why not? (hint: think about the effect this policy has on real exchange rate)

Answer 1

a.)

No, trade deficit is not always a bad thing. A country which runs a trade deficit in general imports more than it exports. This is not a bad thing, as it simply means that the country finds exports from other nations cheaper than its own exports to other nations. This will inadvertantly mean that the nation as a very strong currency, and that its currency has appreciated more with respect to the other nations. It also means that the nation has more capital inflow which is required to balance the trade deficit, to keep the balance of payments acocount balanced. Hence, it will mean the generation of more investment in the domestic industries and businesses as well. Further, a nation with a lot of export earnings is often very vulnerable to global economic cycles. This means that the domestic economy will take a serious hit whenever the economies of their largest export partners takes a hit. For example, the Chinese economy is an export-oriented economy, which means that their major source of income is their exports, and the US is their largest export partner. Hence, when the US economy crashed in the 2008 Financial Crisis, the Chinese economy also suffered massively, even as the Crisis had no direct affect on their business.

b.)

If the government provides export subsidies, then the export sector will flourish and the economy will have more export earnings. This means that the other nations that export from the domestic nation will demand more of the domestic currency to be able to pay for the exports. In this case, the currency will appreciate, because the demand increases and supply is more or less the same. This means that in the future, the domestic currency will appreciate, and domestic exports will become more expensive for the importing nations. This will cause the other nations to reduce their demand for the domestic exports. Hence, the nation's exports will reduce, and the appreciation of the currency will mean that the domestic residents will find the international goods cheaper and the domestic imports will increase. Thus, the nation's trade balance will deteriorate in the future.