Learning Objectives
By the end of this section, you will be able to do the following:- Discuss twin deficits as they related to budget and trade deficit
- Explain the relationship between budget deficits and exchange rates
- Explain the relationship between budget deficits and inflation
- Identify causes of recessions
Government budget balances can affect the trade balance. As The Keynesian Perspective chapter discusses, a net inflow of foreign financial investment always accompanies a trade deficit, whereas a net outflow of financial investment always accompanies a trade surplus. One way to understand the connection from budget deficits to trade deficits is that when a government creates a budget deficit with some combination of tax cuts or spending increases, it increases aggregate demand in the economy, and some of that increase in aggregate demand results in a higher level of imports. A higher level of imports, with exports remaining fixed, causes a larger trade deficit. This means foreigners’ holdings of dollars increase as Americans purchase more imported goods. Foreigners use those dollars to invest in the United States, which leads to an inflow of foreign investment. One possible source of funding of the budget deficit is foreigners buying Treasury securities that are sold by the U.S. government. So a budget deficit is often accompanied by a trade deficit.