Question

Commentators often refer to government budget deficits and trade deficits as ‘twin deficits’. Using appropriate diagram/s for the loanable funds market, the net foreign investment and the market for foreign currency exchange, explain how and why a government budget deficit leads to a trade deficit. (10 marks)

Answer 1

Government's own deficit in the budget can perpetuate the deficit in the current account in the form of trade deficit. A government budget deficit is the result of a tax decrease or increased government spending This deficit reduces public saving, then national saving and the deficit is financed by the borrowing from the funds market. This rauses the rate of interest in the economy. At a higher rate of interest, there is an increase in capital inflow and so net capital outflow falls. This implies a decline in net exports as the demand for domestic currency is increased by foreign investors and this cause exchange rate to appreciate Diagramatically, when there is a budget deficit, the loanable funds market experiences a leftward shift of the supply curve. This raises the rate of interest. In the market for saving and investment, this rise in interest rate brings in foriegn capital so that there is a decline in net capital outflow. In forex market, this decline causes the currency to appreciate and hence imports rise while exports fall. As a result, net exports fall and there is a current account deficit. Thus, budget deficit give rise to trade deficit

interest rate SLF1 interest rate SLF e2 e2 i2 el el il NCO DLF NCO1 NCO2 loanable funds LF2 net capital outflow LF1 exchange rate SSi e2 er2 el er1 DD Q2 Q1 quantity of currency SS