Budget deficit and trade deficit in the open IS-LM model
Channel: Werner Lost
Date: 2012-04-03

An explanation is given why an increase in the budget deficit leads to an increase in the trade deficit in the open IS-LM model.  

An increase in the budget deficit of government implies an expansionary fiscal policy.  An expansionary fiscal policy causes an increase in the interest rte which  increases capital inflow and an appreciation of he exchange rate (this is what the interest parity conditon tells us).  This appreciation caused  the price if imports to decrease and the price of exports to increase.  More is imported and less is exported  resulting  in a trade deficit.