Chapter 11: Problem 7

How can a larger government fiscal deficit cause a larger international trade deficit?

Short Answer

Expert verified

A larger government fiscal deficit can lead to a larger international trade deficit due to the following reasons: 1. An increase in government spending contributes to a rise in aggregate demand, which leads to higher levels of domestic consumption. As a result, consumers and businesses tend to import more goods and services to meet the increased demand, causing imports to rise. 2. A larger fiscal deficit may also cause the local currency to depreciate due to the government issuing new bonds or increasing the money supply by borrowing from central banks. This depreciation makes imported goods more expensive, contributing to a larger trade deficit. These factors demonstrate the relationship between fiscal policy and international trade and how larger government fiscal deficits can contribute to larger international trade deficits.

Step by step solution

Understanding Fiscal Deficit and International Trade Deficit

Fiscal deficit occurs when a government spends more money than it collects through taxes and other sources of revenue. International trade deficit, on the other hand, arises when the value of a country's imports exceeds the value of its exports.

Explaining the Link between Fiscal Deficit and Aggregate Demand

An increase in government spending (part of the fiscal deficit) leads to an increase in aggregate demand. This is because government spending stimulates economic activity, as it directly purchases goods and services from the private sector and also indirectly supports demand by increasing transfer payments or lowering taxes.

Impact of Aggregate Demand on Imports and Exports

A rise in aggregate demand affects the level of goods and services demanded domestically. When domestic demand increases, consumers and businesses tend to import more goods and services to meet the higher demand. Consequently, imports rise, which can lead to a higher international trade deficit if exports do not increase at the same pace.

Effect of Fiscal Deficit on Exchange Rates

A larger fiscal deficit might lead to a depreciation of the local currency. To finance the deficit, the government may issue new bonds or increase the money supply by borrowing from central banks. This could cause inflation and lead to a decrease in exchange rates. When the local currency depreciates, imported goods become more expensive, which can lead to a larger trade deficit.

Relating the concepts: Fiscal Deficit and International Trade Deficit

To summarize, a larger government fiscal deficit can cause a larger international trade deficit through the following mechanisms: 1. An increase in government spending raises aggregate demand, leading to higher imports. 2. A larger fiscal deficit might lead to a depreciation of the local currency, making imported goods more expensive and widening the trade deficit. Understanding these connections helps to explain the relationship between fiscal policy and international trade and demonstrates how larger government fiscal deficits can contribute to larger international trade deficits.