Question

Under what conditions will a larger budget deficit cause a trade deficit?

Short answer

Private savings are insufficient to offset spending, and private investment is not totally crowded out.

Step-by-step solution

Definition

A trade deficit occurs when the value of a country's imports exceeds the value of its exports. Both products and services are subject to imports and exports. Simply, when a country buys more goods and services than it sells, it has a trade imbalance.

Explanation

When private savings do not fully offset spending and private investment is not totally crowded out, a greater budget deficit will result in a rise in the trade deficit. Budget deficits lead to higher interest rates. High interest rates attracts capital inflow. As the demand for domestic currency increases, the value of the currency appreciates. This further makes exports expensive lead to a decline in export demand.