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Budget deficits and exchange rates

Exchange rates can also help to explain why budget deficits are linked to trade deficits. [link] shows a situation using the exchange rate    for the U.S. dollar, measured in euros. At the original equilibrium (E 0 ), where the demand for U.S. dollars (D 0 ) intersects with the supply of U.S. dollars (S 0 ) on the foreign exchange market, the exchange rate is 0.9 euros per U.S. dollar and the equilibrium quantity traded in the market is $100 billion per day (which was roughly the quantity of dollar–euro trading in exchange rate markets in the mid-2000s). Then the U.S. budget deficit rises and foreign financial investment provides the source of funds for that budget deficit.

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 D 0 to D 1 and the supply of U.S. dollars falls from S 0 to S 1 . At the new equilibrium (E 1 ), the exchange rate has appreciated to 1.05 euros per dollar while, in this example, the quantity of dollars traded remains the same.

Budget deficits and exchange rates

This graph shows the demand and supply of foreign currency. The y-axis shows the euro/U.S. dollar exchange rate and the x-axis shows the quantity of dollars traded. As explained in the text, a budget deficit raises the demand for dollars (and lowers the supply of dollars) because foreign investors want to purchase U.S. government debt. The result is a stronger exchange rate.
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 D 0 to D 1 . 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 S 0 to S 1 . The equilibrium exchange rate strengthens from 0.9 euro/ dollar at E 0 to 1.05 euros/dollar at E 1 .

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 this appreciation of the exchange rate as being driven by interest rates. As explained earlier in Budget Deficits and Interest Rates in Fiscal Policy, Investment, and Economic Growth , 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. The depreciation of the U.S. dollar 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 the connection should not be expected to be one-to-one.

Questions & Answers

what is economics
Julie Reply
what do you mean by means in economics
Julie
economic is the wealth of a country.
Moussa
monetary policy is refer to as being expansionary or contractionary.
Abdul
important of unemployment
Otwe Reply
Important of unemployed
Otwe
important?
Aneela
what is meaning scarcity
ABDULLAHI Reply
what is consumer
Brenda Reply
how do consumer help people
Brenda
by export trading
Jayah
How do you mean Jayah
Danjuma
what is different between price and quantity
Yakubu
what is MRS
Rashid
definition of economics according to Adam Smith
Ijeoma Reply
economic is a wealth of nation
Au
in the view of Adam Smith economics is the study of activities of people in production of wealth
suresh
What do you really think is the remedy for scarcity in Nigeria 🇳🇬
John Reply
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zfekere Reply
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Haruna Reply
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Haruna
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zfekere
mixed economic
tadesse
you have just been appointed in the director of finance for your state internal revenue board with the knowledge of elasticity advice the state government on how the I.G.R of the state could be raised through exercise duties bearing in mind the implication and incident of taxing setting products
Kenechukwu Reply
Hello,Thanks for your replay
Esmael
fine
IDRIS
mention 5 characteristics of traditional societies
Pono Reply
dominance of agriculture and ignorance of development avenues are some characteristics of traditional societies.
sade
what's defined as unemployment
Lyrikal Reply
what is elasticity
Olakunle Reply
Elasticity is defined as the degree of responsiveness of quantity demanded to slight change in price, cost of other products and income of consumer.....
Danjuma
elasticity simply means change. it is the degree of responsiveness of quantity demanded of a commodity to changes in the price of a commodity
Emmanuel
what is monetary policy
Rashid
Monetary Policy; is the objectives of the central bank in exercising its control over money, interest rates, and credit conditions.
Hamed
So does it mean that ceteris paribus is the same as all other things being equal?
Ghabbie Reply
Yes nothing else has been changed
Abi
ways by which trade unoins raise wage of it's members
Ngu Reply
what is economic growth
Victor Reply
increase a amount of goods and services produced as per head of population a period of time
SHOM
Economic growth and development has been defined in so many ways by various economist. At a time past, people started raising questions about having economic growth as the same in meaning development. They do not mean the same thing but they are however interdependent and inter related.
Nder
For economic development is not possible without economic growth but economic growth is possible without economic development. For example, when there is an observed increase in GDP from 3 million to 4 million over a period of 5 years, we say that there is economic growth.
Nder

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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