Question

4. Explain the historical relationship between the US trade deficit and budget deficit? Why do some economists consider this to be problem- atic? Why do some economists consider the (opposite) relationship for China to be problematic? Why do some researchers believe this has not been a historical cause of worry for the US? (You may have to do some research on the last part and some reading ahead on the first). 5. Explain what is meant by covered interest parity (or sometimes in the literature, violations of covered interest parity). Why is this a challenge to the strength of arbitrage theories? What theories exist to explain failures in covered interest parity when it has been documented?

Answer 1

Historically since 1929 the US has faced problems of twin deficit called as budget anf trade deficit in linear direct relationship as the growing expansionary fiscal policy leads to budget deficits or fiscal deficit. Now since government takes more foreign loans it causes the interest rates to go up which in turn leads to US dollars appreciation against basket of currencies and thus imports become cheaper which leads to higher trade deficit. It is problematic as its tradeoff between high GDP growth and low trade deficit and thus exactly opposite is problematic for CHIna because high trade deficit will cause Yuan depreciation against US Dollar and lower GDP growth.

However historically US has maintained fine balance for high GDP growth using Combination of expansionary monetary policy and tight fiscal policy to counterbalance the trade deficit and budget deficits.

Interest parity coverage holds that interest rate differential between two currencies in secondary cash market shall equal the difference between spot and future exchange rates. This now causes challenges to arbitration as one has to bear losses when interest rates between two nations is substantially low which gives lower headroom for arbitrage and profit booking. It largely fails due to underlying credit risks and systemic risks and assymetric information to buyers and sellers.

PLEASE UPVOTE INCASE YOU LIKED THE ANSWER WILL BE ENCOURAGING FOR US THANKYOU VERY MUCH ALL THE BEST IN FUTURE.