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Chapter 18: Q.9 (page 451)

Under what conditions will a larger budget deficit cause a trade deficit?

Short Answer

Expert verified

Private savings are insufficient to offset spending, and private investment is not totally crowded out.

Step by step solution

01

Definition

A trade deficit occurs when the value of a country's imports exceeds the value of its exports. Both products and services are subject to imports and exports. Simply, when a country buys more goods and services than it sells, it has a trade imbalance.

02

Explanation

When private savings do not fully offset spending and private investment is not totally crowded out, a greater budget deficit will result in a rise in the trade deficit. Budget deficits lead to higher interest rates. High interest rates attracts capital inflow. As the demand for domestic currency increases, the value of the currency appreciates. This further makes exports expensive lead to a decline in export demand.

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Most popular questions from this chapter

What is the theory of Ricardian equivalence?

Explain how a shift from a government budget deficit to a budget surplus might affect the exchange rate.

Illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph.

What must take place for the government to run deficits without any crowding out?

Assume there is no discretionary increase in government spending. Explain how an improving economy will affect the budget balance and, in turn, investment and the trade balance.
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