Answer to Question #190812 in Economics for shargeel khan

Question

Explain what will happen to the country currency when the government has a large budget deficit.

Answer 1

The state borrows money to cover the increased state budget deficit, thereby reducing the supply of free borrowed funds that could be used by the private sector for investment.

As a result, we have an increase in the real interest rate. At the same time, the increase in the interest rate is forcing a certain part of potential borrowers to abandon plans for investment lending. Such a decrease in investment activity, formed under the influence of an increase in the volume of government borrowed, is called displacement.

If the real interest rate increases, then this should attract non-residents wishing to invest money in domestic assets since the cost of borrowed funds in the external market has become relatively lower. At the same time, some of the domestic investors who have assets in a foreign currency will also place their funds in national assets. Thus, net foreign investment in the economy is declining.

Since domestic investors now need less foreign exchange to acquire foreign assets, the supply of the national currency in the market will decrease, which is actually reflected in an increase in the nominal exchange rate of the national currency. And this, in turn, leads to an increase in the cost of domestic goods relative to foreign ones. Consequently, imports are growing and exports are decreasing, that is, the trade balance is decreasing.

Conclusion: an increase in the state budget deficit leads to an increase in the real interest rate, as well as a decrease in foreign investment, an increase in the exchange rate of the national currency, and, accordingly, a decrease in net exports (the trade balance).