Final answer:
A budget deficit leads to an appreciation of the dollar because of increased foreign demand for U.S. government debt, making U.S. exports more expensive and imports cheaper, thus causing a trade deficit. The Keynesian view also suggests that budget-deficit-stimulated aggregate demand leads to higher imports and, with constant exports, a larger trade deficit.
Step-by-step explanation:
To understand how a budget deficit causes a trade deficit, we start by examining the impact on the exchange rate when there is an increased demand for U.S. government debt by foreigners. When the U.S. government runs a budget deficit, it needs to borrow money to finance the gap between its spending and revenue. One way to borrow is by selling Treasury securities, which are often bought by foreign investors. As demand for these securities rises, the demand for U.S. dollars also increases since they must be purchased in dollars.
This increased demand causes the value of the dollar to appreciate relative to other currencies. A stronger dollar makes U.S. exports more expensive and imports cheaper, which increases the quantity of imports and decreases the quantity of U.S. exports, leading to an increase in the trade deficit (when imports exceed exports). The connection between the two deficits is often referred to as the twin deficits. Another perspective is to consider the Keynesian view, where a budget deficit, stimulated by tax cuts or spending hikes, will increase the overall aggregate demand in the economy. Part of this increased demand results in higher imports, with fixed exports, leading to a wider trade gap. Foreigners will then use the dollars from their increased sales to invest in U.S. assets. Thus, a budget deficit funded by foreign investment is associated with a trade deficit since the increased consumption usually involves purchasing foreign goods.