Question

"Twin deficits" refers to a​ situation, where the government budget deficit

A. leads to a capital account deficit.

B. leads to a current account deficit.

C. leads to a balance of payment deficit.

D. leads to a financial account deficit.

Answer 1

The term 'twin deficits' refers to the situation where a government budget deficit leads to an increase in aggregate demand and consequently results in a current account deficit due to higher imports and constant exports.

Step-by-step explanation:

The term twin deficits refers to the simultaneous occurrence of a government budget deficit and a current account deficit, meaning the correct answer to the student's question is B: leads to a current account deficit.

When a government runs a budget deficit, this can lead to an increase in aggregate demand which often results in higher imports. If the exports remain constant, the result is a larger trade deficit. Since the trade balance is a major component of the current account, a government budget deficit can lead to a current account deficit.

This relationship was notably observed in the mid-1980s in the United States where a significant rise in government borrowing matched by an inflow of foreign investment resulted in both the budget deficit and the trade deficit increasing together, hence the concept of 'twin deficits'. International financial investors funding the budget deficit may invest in Treasury securities, further linking these two types of deficits.