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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 economics
Toyin Reply
Is this a question?
Tala
What is populatiin
Azer Reply
Population is a number of people living in a particular area within a particular time
Rabby
Population is the number of people living in a particular geographical area within a particular time
Rabby
how does this chat work
Dalaya
ya the ideas are good thanks friends
South
so what's the next question?
South
what is demand schedule
Toyin Reply
is a tabular representation of the quantity demanded of a particular product at a particular price over a given period of time
Loveth
thanks
Toyin
What is Monetary Mass
Acha Reply
who is product of traditional economy
jamal Reply
what is elasticity
Suqlain Reply
change in quantity due to change in its price
sj
degree of responsiveness of quantity demanded or supplied due to price.change
Loveth
The law of demand and supply
RICHARD Reply
Law of demand...keep other things constant when price of commodity increases demand is decreases n price decreases demand increases.
sj
law of supply.. keep other things constant when commodity prices increase supply is also increased n price decreases supply is also decreased.
sj
Wow
RICHARD
Thank you
RICHARD
when prices increases causing demand curve to shift to left holding other variables constant.
Amos
what is the difference between quantity demanded nd price
Survival Reply
what is the difference between quantity demand and price
Md
There is an inverse relation between price and the quantity demanded...with the increase in price of a commodity, the demand for the commodity decreases and vice versa..
Malik
professor lionel Robbins define economics as a
ISAAC Reply
as the science that studies human behavior as the relationship between earn and scarce means which has alternative uses
Akon
study of wealth
Suqlain
explain the help of a production possibility diagram how the opprtunity cost of producing different combinations of goods
Leethwinna Reply
what is the measurements of elasticity
Nessa Reply
?
Ateh
what are the shift in demand
Mbah Reply
what is monopoly
Oumar
monopoly is a structure in which there's only one producer/seller for a product
Esther
The difference between change in quantity demand and change in demand
EDMOND
single seller. compare with monopsony (single buyer) & duopoly (two sellers), and oligopoly (>2 sellers) These are about distortions to an ideal competitive market.
Henry
Why is the nature of demand curve sloping downward?
Julie
Because when price increases Demand Decreases
Getu
shift in demand is a movement from one demand curve to another
Yollins
what is Monopoly
Faith Reply
monopoly is a market with no competition, and firms have complete market power. Firms are price makers not price takers.
Bernard
thanks so much
Faith
U are welcome
Bernard
what are the negative effects of deflation to central government?
Ali
What is localization
Abiodun
How many brunches of economics is there?
Desca Reply
Three
Yakub
Is that true
Asifat
did you mean branches
Sam
That's what he meant
Asifat
2 brunches..microeconomics and macroeconomic
sj
there are many more categorizations than the classic macro/micro. International, labor, public finances, monetary, information, ...many more. I'd be surprised at anything less than 15.
Henry
Explain a demand curve
Danny Reply
A demand curve is a graphical illustration of the inverse relationship between quantity demanded and price. It slopes downwards from left to right. it is a negative curve.
Loveth
demand curve is graphical representative of the inverse relationship between price an quantity demanded an price
Eliman
sorry for doubling of "price"
Eliman

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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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