Y5

Twin Deficits", NX=NFO It's often said that the government deficit and the trade deficit are twins: countries that have a budget deficit (T < G) will often have trade deficits (NX < 0), and vice versa. Use the 3-part diagram (Savings/Investment, NFO, NX) to answer this question.

a) Let's look at a large open economy (like the US). Start by assuming that G=T: there is no budget deficit. Set up the initial 3-part diagram to show how the equilibrium real interest rate is determined, how that interest rate determines Net Financial Outflows, and how Net Financial Outflows and Net Exports together determine the exchange rate.

b) Now suppose that government spending increases but tax collections remain the same - the increase in spending causes a budget deficit. Show how the increase in government spending changes interest rates, NFO, NX, and the exchange rate. Does the dollar appreciate or depreciate? What happens to the trade deficit? Be sure to explain the economics along the way: why does a change in the interest rate affect NFO? Why does a stronger/weaker dollar change NX?

c) Using these results, briefly explain the logic of why the budget deficit and trade deficit are "twins." What source(s) of money fund the increased budget deficit?