Finance Questions 5 2-2

1. Japan once argued that the main reason the US had large trade deficits during the 1980s and 90s was because of its large federal government budget deficit. If the US wanted to reduce its trade deficit, Japan said, then it needed to reduce its budget deficit. Use the twin-deficit identity to answer the following questions.

a. Explain what would have to also hold for there to be a direct relationship between budget deficit changes and trade deficit changes?
b. Is it possible to account for a reduction in the federal government budget deficit and a simultaneous increase in the current account deficit? Explain.

c. Is it possible to reduce the federal government budget deficit, maintain the same level of net private saving (i.e., S_p - I) and still experience an increase in the current account deficit? Explain.

International Finance Theory and Policy - Chapter 5: Last Updated on 1/5/08