How can a larger government fiscal deficit cause a larger international trade deficit?

Question

Please help me I am stumped with this question. Thank you very much!

Answer 1

The government deficit (or borrowing, More specifically)decreases the amount of funds banks have available for loans. The increased borrowing causes interest rates to rise (a phenomena known as Crowding Out) .

These higher interest rates, in return, increase the value of a nation's currency as more foreigners seek to try to take advantage of higher real interest rate returns. (A phenomena known as Capital Flows)

Finally, as the currency appreciates, the price of goods and services in that nation rises with it (for foreigners) and decreases exports to foreigners. This makes the trade deficit higher.

Check out reffonomics.com virtual textbook on "Twin Deficits" for more info.