Because of the close co-movement between the budget deficit and the current account deficit, the two are often referred to as “twin deficits”. Explain in detail how an increase in the budget deficit that is due to an increase in government spending (not matched with an increase in taxes) will generate a current account deficit. Clearly explain the role of the interest rate and the exchange rate for the link between the budget deficit and the current account deficit. B) Describe the various factors that investors take into account when operating in the context of an open economy and discuss, in detail, how each of these factors affects their decisions to invest domestically or abroad. Give examples to illustrate your answers. Solution A) A common view held by economists is that an increasing current account deficit indicates that a nation is “living beyond its means” – with excessive domestic demand boosting imports and fuelling inflation, which undermines the competitiveness of the nation and restricts exports. They point to the fact that the current account deficit is a measure of the nation’s overseas borrowing. So for each quarter that the economy is in external deficit, its stock of foreign liabilities increase. These liabilities can be in the form of debt or equity participation in local firms. Following this logic, an increasing current account deficit indicates that local consumption and investment is becoming increasingly dependent on the whims of foreign lenders. They also argue that there is a strong and direct relationship between the national economy’s current account balance and its government budget balance and can become twinned” – that is, move together dollar-for-dollar. This is the twin deficit hypothesis. The hypothesis is based on national accounting relationships that can be used to show that a current account deficit measures the difference between total domestic (public and private) saving and investment. This viewpoint considers “national” saving to be the sum of private saving and budget surpluses and total investment to be the sum of private and public capital formation. Accordingly, if the budget moves into deficit, they consider national saving to have fallen and/or national investment to have risen, depending on whether the rise in the deficit is driven by public consumption or investment spending. Accordingly, other things equal, an increase in the budget deficit will result in a rise in the current account account deficit Further, if the nation has an increasing budget deficit, it is to be increasingly dependent on the foreign purchases of its debt to supplement domestic savers’ purchases of government debt. So both a rising budget deficit and rising current account deficit indicate an increased reliance on foreign debt purchases, which according to this viewpoint renders the domestic economy vulnerable to unexpected and sudden changes in economic fortunes. Proponents of this viewpoint suggest that the risk of t.