Question

How does an increase in government purchases financed by an increase in the deficit affect exchange...

How does an increase in government purchases financed by an increase in the deficit affect exchange rates? Support your answer with graphs of the loanable funds market and the foreign exchange market.

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Answer #1

When government deficit rises, it indicates that government debt or borrowing has increased significantly. It pushes up interest rate in market. It will induce more inflow of capital from overseas, So real exchange rate will rise or domestic currency will appreciate.

Following is diagram:

In above diagram, When government expenditure rises, there is shift in S-I curve to left thereby reducing Next export driving up Exchange rate.

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