What is the relationship between the budget deficit and the trade balance?

The budget deficit occurs when the expenditure of the government (spending) in more than its revenue. Thus, two components of the deficit are revenue and expenditure. The trade balance is the difference between the exports and the imports of a country. The trade balance can be a surplus or a deficit. The trade balance is a deficit when the imports are greater than the exports.

When the government faces a budget deficit, they compete with private investments for savings, driving up the interest rate. When the interest rate increases, domestic assets become more attractive to foreigners, who trade in their foreign currency for domestic currency in order to buy these domestic assets. This higher demand for domestic currency increases the real exchange rate, and as a result, the foreign goods now appear much cheaper than domestic goods, so imports increase and exports decrease, all else being equal.

Therefore, the trade deficit increases when the budget deficit increases. When the trade deficit and budget deficit occur together, it is known as the twin deficit.