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(a) Explain why a government should avoid a large and persistent balance of trade surplus and deficit. [10]

Introduction

Balance of trade refers to the difference between a country's export revenues and import expenditures. A trade surplus occurs when export revenues exceed import expenditures, while a trade deficit arises when import expenditures exceed export revenues. While having either a surplus or a deficit in the short term is not inherently problematic, a large and persistent balance of trade surplus or deficit can have significant implications for an economy. 

Why governments should avoid large and persistent trade deficits

A persistent trade deficit can be symptomatic of underlying structural weaknesses in an economy. If a country consistently imports more than it exports, it may indicate that its exports are not competitive in global markets. This could be due to factors such as high production costs, high labour costs, or low levels of innovation. For example, if domestic industries are unable to compete with foreign producers due to inefficient production methods, the economy might rely too heavily on imports to meet consumer and business needs. Over time, this reflects greater issues such as declining industrial competitiveness, which could lead to further economic difficulties.

Furthermore, a large and persistent trade deficit can lead to the depletion of a country's foreign exchange reserves. In a trade deficit, a country must pay for its imports with foreign currency. If it runs a deficit for an extended period, it may eventually run down its foreign exchange reserves, which are crucial for stabilising the exchange rate and supporting international trade. Once these reserves are depleted, the country may need to borrow from foreign lenders, thereby incurring foreign debt. 

Additionally, a large and persistent trade deficit may lead to the depreciation of the currency. When a country imports more than it exports, the demand for foreign currencies increases, while the demand for its domestic currency decreases, leading to a fall in the value of the domestic currency relative to others. While depreciation can, in theory, make exports cheaper and more competitive, the short-term effects can be damaging. A weaker currency increases the cost of imports, particularly essential goods such as fuel and raw materials, leading to imported inflation. Higher inflation further erodes purchasing power, affecting consumers and increasing production costs for businesses reliant on imported inputs, thereby deepening the economic challenges posed by the trade deficit.

Why governments should avoid large and persistent trade surpluses

While trade surpluses are generally more favourable than deficits because they allow a country to build foreign exchange reserves, large and persistent surpluses can also present problems. A persistent trade surplus may indicate low levels of import expenditure, which can suggest that domestic consumption is weak. If households and businesses are not spending enough on imported goods, it could be a sign of low domestic demand and low standards of living. For instance, if a country's consumers are spending less on imported luxury goods, advanced technology, or services, it could reflect a low consumption culture, which may keep the standard of living lower than it could be.

Moreover, if a country is running a large trade surplus for an extended period, it may face international trade tensions. Other countries may view the surplus as an indication of unfair trade practices, such as artificially devaluing the currency to make exports cheaper. This can lead to protectionist measures from other countries, such as tariffs or quotas, which could harm the economy in the long run. For example, China has often been accused of running large trade surpluses through such means, leading to trade conflicts with major trading partners like the U.S.

Conclusion

In conclusion, while short-term trade imbalances may not be a cause for concern, large and persistent trade deficits and surpluses can have serious negative consequences for an economy. A government should avoid persistent trade deficits to prevent a loss of competitiveness, depletion of foreign exchange reserves, and the accumulation of foreign debt. Similarly, while trade surpluses can help build foreign reserves and are generally preferred, large and persistent surpluses may indicate low domestic consumption and could lead to international trade conflicts.