An increase in U. S. federal government budget deficits that raises U. S. interest rates relative to the rest of the world should

A.

raise the trade balance.

B.

lead to a current account deficit.

C.

increase net exports.

D.

decrease foreign portfolio investment.

Answer: B. lead to a current account deficit.

A US Federal government budget deficit indicates that the planned expenditure by the government exceeds the revenues received by the government. The government needs to look for additional sources of funds to fuel the planned expenditure.

When this happens the U. S government can rise interest rates relative to the rest of the world. When interest rates rise, international investors will prefer to invest in the U. S on account of the higher interest rates. This inflow from international investors fund the budget deficit.

As foreign investors queue up to invest in the U. S, the demand for U. S. Dollar increases in the foreign exchange market. This results in an appreciation of the USD, i. e it costs more to buy one USD after the increase in interest rates than before.

A strong dollar in turn results in reduced exports and cheaper imports that result in a trade deficit.

The trade deficit forms the biggest component of the current account deficit.