Question

Commentators often refer to government budget deficits and trade deficits as "twin deficits". Explain how the two types of deficit are related.

Answer 1

Trade deficit occurs when the imports are more than exports. Government budget deficits occur when the expenditure of government is more than the revenues and income generated.

Twin deficits are related because when government reduces taxes and the spendings remain the same, then there would be budget deficit as stated in the definition above. This would mean that the government in order to finance the spendings, would borrow from the rest of the world , which would mean that there would be trade deficit.

In other words, when there is budget deficit, it means that the national savings of the economy has reduced. This would imply that the interest rates would rise, which would reduce domestic investments and also the exports would reduce. . All these combined with the same level of imports would mean that the real exchange rate would rise. More of the domestic currency would be required for an additional unit of foreign currency. This would lead to trade deficit.

Hence both these occur together.