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Explain why a budget deficit causes a trade deficit. Include the graphs for the market for...

Explain why a budget deficit causes a trade deficit. Include the graphs for the market for loanable funds and currency exchange market in your answer.

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We take example of usa

Budget deficit means Govt spends more than its revenue. This can be financed by borrowing from loanable funds market. Hence demand for loanable funds rises from D to D1. As a result interest rate rises from r1 to r2

Consequently in foreign exchange market demand for dollars rises from D1 to D2 since foreign investors invest in usa in order to get higher returns in usa as interest rate is higher in usa. Hence exchange rate rises from 1 to 2 euros per dollar. This means currency of nation appreciates which reduces exports since they now become costly for foreigners and increases imports since they now become cheaper. Thus there results trade deficit

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