Question

how can fiscal policy lead to changes in the foreign exchange market that reduces our net exports, thereby reducing the benefit of the policy

Answer 1

Fiscal policy of expansion can reduce net benefits to the society by reducing net exports. It happens when government increases its expenditure and in order to finance its deficit, it borrows from loanable funds market. There is an increase in the rate of interest in domestic funds which attracts foreign investors. as the demand for domestic capital increases by foreign investors there is an increase in demand for domestic currency. This appreciates its value and causes imports to increase and exports to decline. Overall net exports are reduced and there is a trade deficit.

In this manner fiscal expansion that brings budget deficit also causes trade deficit.