How do Exchange Rates Affect Budget and Trade Deficits?

Exchange rates can also help to explain why budget deficits are linked to trade deficits.

International financial investors, as a group, will demand more U.S. dollars on foreign exchange markets to purchase the U.S. government bonds, and they will supply fewer of the U.S. dollars that they already hold in these markets. Demand for U.S. dollars on the foreign exchange market shifts from D₀ to D₁ and the supply of U.S. dollars falls from S₀ to S₁. At the new equilibrium (E₁), the exchange rate has appreciated to 1.05 euros per dollar while, in this example, the quantity of dollars traded remains the same.

Imagine that the U.S. government increases its borrowing and the funds come from European financial investors. To purchase U.S. government bonds, those European investors will need to demand more U.S. dollars on foreign exchange markets, causing the demand for U.S. dollars to shift to the right from D₀ to D₁. European financial investors as a group will also be less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S₀ to S₁. The equilibrium exchange rate strengthens from 0.9 euro/ dollar at E₀ to 1.05 euros/dollar at E₁.

A stronger exchange rate, of course, makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results. Thus, a budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.

You can also imagine interest rates are driving the exchange rate appreciation. 

A budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. U.S. dollar depreciation leads to a larger trade deficit (or reduced surplus). The connections between inflows of foreign investment capital, interest rates, and exchange rates are all just different ways of drawing the same economic connections: a larger budget deficit can result in a larger trade deficit, although do not expect the connection to be one-to-one.

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