Question

QUESTION 3 10 MARKS
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.

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 DLF NCO NCO2 NCO1 LF2 LF1 loanable funds net capital outflow exchange rate SSiss e2 N er 1 DD Q2 Q1 quantity of currency