Question

Which of the following explains why a budget deficit can cause a trade deficit?
A) An increase in the budget deficit raises domestic interest rates, resulting in a
current account surplus and an appreciation of its currency.
B) An increase in the budget deficit lowers domestic interest rates, resulting in a
current account deficit and a depreciation of the currency.
C) An increase in the budget deficit raises domestic interest rates, resulting in a capital
account surplus and an appreciation of the currency.
D) An increase in the budget deficit lowers domestic interest rates, resulting in a
capital account deficit and a depreciation of the currency.

Answer 1

Ans. Government budget deficit means that the Treasury must issue more bonds. This reduces the price of the bonds and raises the interest rates. Due to the increased interest rates there would be an inflow of foreign investment in the country and this will result in capital account surplus. Capital account surplus will lead to appreciation of the currency.

C) An increase in the budget deficit raises domestic interest rates, resulting in a capital account surplus and an appreciation of the currency.