Question

a.What are the links between the budget deficit and trade deficit? What would be the most effective way to reduce the trade deficit.

b.How has COVID-19 affected the budget deficit? Be specific.

Answer 1

a) Government budget deficits and trade deficits are sometimes called the twin deficits because a government budget deficit often leads to a trade deficit. The government budget deficit leads to reduced national saving, causing the interest rate to increase, and reducing net capital outflow.The decline in net capital outflow reduces the supply of dollars, raising the real exchange rate.Thus, the trade balance will move toward deficit. As deficit spending goes up, it is likely government borrowing will, too. Then foreign residents who lend funds to the U.S. government have less to spend on our goods, so U.S. exports will fall.

Methods to reduce Trade Deficit

Consume Less and Save More.

If US households and Government reduce their consumption expenditure and start saving more then Trade deficit can be reduced. Due to less consumptions imports will drop. As a result borrowings from abroad will be reduced. This means that consumption taxes could help reduce the deficit, by discouraging consumption, increasing saving, and reducing the government deficit.

Depriciate Exchange Rate

A currency depreciation will lead to lower imports and higher exports, thereby improving the current account balance, by reducing the deficit or increasing surplus. A currency depreciation causes net exports to increase and therefore an increase in real GDP. However, the increase may only be temporary due to strong inflationary pressures.

Tax Capital Inflows

Taxing capital inflows is a far better way to balance trade than imposing tariffs. This would address the root causes of trade imbalances, improve the productive investment process, and shift most of the adjustment costs onto banks and speculators.

b) Effect of Covid 19 on Budget Deficit

• Due to Covid 19 there is shortage of ventillators, hand sanitizers. The economic activity is completely shut down. People are unemployed and have no source of income.  Most states are in such dire financial straits that some politicians have even proposed letting them file for bankruptcy. Government has to provide stimulus packages to the citizens. Deficits of consumption and production are guaranteed to produce deficits on the government’s balance sheet.
• Excess deaths have come alongside excess debt. The CBO estimates that federal government debt will be 101% of GDP by the end of this year, and approaching 108% by the end of 2021. Government Expenditure will increase a lot due to relief programs thus further increasing the budget deficit.
• US Government is handing out cash to households, helping firms pay workers’ salaries, and guaranteeing debt so that companies can stay afloat. All this has increase the budget deficit.
• In the United States, the Federal Reserve has created money to buy securities on the open market.The number of bonds it has bought could double or almost triple over the course of the year. The Federal Reserve is also buying new types of assets in new ways. It has promised to buy $600 billion in loans to small- and medium-sized businesses and $500 billion in bonds issued by certain state and local governments. All these steps are being taken to increase money supply in the economy. But it will aslo increase the budget deficit.

To conclude it hard to project what effect the vast increase in government borrowing will have and difficult to assess who, ultimately, will pay the price.