Sketch a diagram of how a budget deficit causes a trade deficit. (Hint: Begin with what will happen to the exchange rate when foreigners demand more U.S. government debt.)

Budget Deficit:

A budget deficit occurs when a country's government spends more money than it receives in revenue. Budget deficits are sometimes thought to be beneficial to the economy because it is assumed that all of the money spent goes toward productive goals for the country.

Schedule for Demand-Supply.

DD - The demand curve for the US dollar at its inception.

D'D' - A new demand curve for US dollars has emerged.

SS - The U.S. dollar's original supply curve in the European market.

S'S' - In the European market, a new supply curve for US dollars has emerged.

P - Price of the original exchange rate

P' - Price of the new exchange rate

When the United States faces a budget deficit, it will opt to implement programs to close the gap with a surplus. Let's pretend that sells treasury bills to European countries. The dollar market is currently at equilibrium E. The demand for dollars in the European market will shift to the right to D'D' as European citizens seek more dollars to acquire the bills. Also, existing dollar holders will not supply the same amount in the market, shifting the supply curve to the left to S'S'. At E', the balance will be achieved. The value of the euro against the dollar will rise.

As a result, the United States will see a drop in exports as its goods become more expensive. Imports, on the other hand, will rise due to the increase in the exchange rate. As a result, a trade deficit will develop from higher imports and fewer exports.