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Suppose a country was facing the problem of budget deficit and by reducing government expenditures the...

Suppose a country was facing the problem of budget deficit and by reducing government expenditures the government has achieved the target of balanced budget. With the help of appropriate diagrams explain how a country’s shift from budget deficit to balanced budget would affect its investments, economic growth, net capital outflow and currency exchange rate?

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Answer #1

Reducing government expenditure will lead to a leftward shift in the IS curve as a result

Output will decrease and the interest rate will decrease as a result cost of borrowing will decrease and investment expenditure will increase, as output contracts economic growth will decrease, as interest rate decreases capital inflow will decrease if the interest rate is lower compared to the rate of interest in world market as result net capital outflow will be positive and as capital inflow decreases and outflow increases the demand for domestic currency decreases and forex increases the exchange rate will depreciate

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