Question

Assuming the exchange rate is the foreign currency price of dollars (x), use an appropriate diagram and describe the effect of a domestic increase in G (i.e., our government increases its spending) on the value of the foreign currency.

Answer 1

Higher government spending will increase aggregate demand, which will increase the demand for imports. Higher import demand will increase the demand for foreign currency and decrease the demand for dollars. The demand curve for foreign currency will shift rightward, increasing exchange rate (and appreciating foreign currency) and increasing the amount of foreign currency.

In following graph, exchange rate (P) and quantity of foreign currency is measured vertically and horizontally respectively. D0 & S0 are initial demand & supply curves of foreign currency, intersecting at point A with initial exchange rate P0 & initial quantity of foreign currency Q0. When D0 shifts right to D1, it intersects S0 at point B with higher exchange rate P1 and higher quantity of foreign currency Q1.