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Assume that the government budget is initially in balance, but then an increase in government expenditure...

Assume that the government budget is initially in balance, but then an increase in government expenditure causes a budget deficit. If people think the government will cover this deficit by printing money, will the currency appreciate or depreciate, or is it uncertain? What is the effect on equilibrium GDP? Explain with reference to an AA-DD graph.

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Answer #1

This deficit financing by currency printing will increase currency supply and hence the value of currency declines and currency depreciates.

AA curve is downward sloping and shows a combination of exchange rate and output that are consistent with equilibrium in domestic money market and foreign exchange market. Increase in domestic output leads to rise in domestic interest and thus domestic currency appreciation.

DD curve is upward sloping and shows a combination of exchange rate and output that are consistent with equilibrium in aggregate demand and aggregate supply. Increase in exchange rate leads to increase in output.

Currency printing will increase AA and shift AA to right. this leads to increase in the exchange rate and output.

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