Q2.

The twin deficit hypothesis claims that there is a link between fiscal deficit and trade deficit. The story goes as follows. If the government borrowing pushes up the interest rate, the higher return will attract foreign funds. This pulls the currencies held by foreigners away from purchasing exports towards investing in financial assets, so the budget deficit is accompanied by a trade deficit. Do you agree or disagree with this hypothesis? How would your answer change if the economy were initially at a liquidity trap?

• Explain your answer drawing a diagram with the IS-LM model. (Hint: Consider a fiscal expansion. Assume that consumption, investment, and net export are all functions that decrease with an increase in the interest rate.)