Question

A government began 20XX with a budget surplus and a trade deficit. The government changed its policy and is now running a budget deficit. If all other factors remain constant, this change in policy will lead to:
Group of answer choices

A. a decrease in the trade deficit without any affect on the exchange rate.

B. a decrease in both the exchange rate and the trade deficit.

C. increased government borrowing and an increase in the trade deficit.

D. an increase in government borrowing and a decrease in the trade deficit.

Answer 1

Budget Deficit = G - T where G= total Government Expenditure and T = Total government earnings inclusive of taxes revenue and non tax revenues

Trade Deficit = Imports - Exports = M-X

Economy equation is Output = Consumption + Investment + Net Exports + Net Government Expenditure

= > Y = C+ I + (X-M) + (G-T)

= > If all other factors are constant and a policy is such that it shifts the Budget surplus to Budget Deficit , this means the policy has caused increased government expenditure of decreased revenue receipts of government. Now the increased government expenditure is either directly leading to increased imports by government or indirectly because from increased government expenditure the output rises thus leading to more imports for the purpose of consumption by economic entities . Thus leading to increased Import bill and increased trade deficit and increased government borrowing ( since its expenditure is now more than earnings). Moreover even if government faces a budget deficit now due to lowering of taxes then this implies industries and /or individuals have more purchasing power and increased demand , thus reducing the exports and causing increased trade deficit. Thus option C is most likely here .