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Budget deficits and exchange rates

Exchange rates can also help to explain why budget deficits are linked to trade deficits. [link] shows a situation using the exchange rate    for the U.S. dollar, measured in euros. At the original equilibrium (E 0 ), where the demand for U.S. dollars (D 0 ) intersects with the supply of U.S. dollars (S 0 ) on the foreign exchange market, the exchange rate is 0.9 euros per U.S. dollar and the equilibrium quantity traded in the market is $100 billion per day (which was roughly the quantity of dollar–euro trading in exchange rate markets in the mid-2000s). Then the U.S. budget deficit rises and foreign financial investment provides the source of funds for that budget deficit.

International financial investors, as a group, will demand more U.S. dollars on foreign exchange markets to purchase the U.S. government bonds, and they will supply fewer of the U.S. dollars that they already hold in these markets. Demand for U.S. dollars on the foreign exchange market shifts from D 0 to D 1 and the supply of U.S. dollars falls from S 0 to S 1 . At the new equilibrium (E 1 ), the exchange rate has appreciated to 1.05 euros per dollar while, in this example, the quantity of dollars traded remains the same.

Budget deficits and exchange rates

This graph shows the demand and supply of foreign currency. The y-axis shows the euro/U.S. dollar exchange rate and the x-axis shows the quantity of dollars traded. As explained in the text, a budget deficit raises the demand for dollars (and lowers the supply of dollars) because foreign investors want to purchase U.S. government debt. The result is a stronger exchange rate.
Imagine that the U.S. government increases its borrowing and the funds come from European financial investors. To purchase U.S. government bonds, those European investors will need to demand more U.S. dollars on foreign exchange markets, causing the demand for U.S. dollars to shift to the right from D 0 to D 1 . European financial investors as a group will also be less likely to supply U.S. dollars to the foreign exchange markets, causing the supply of U.S. dollars to shift from S 0 to S 1 . The equilibrium exchange rate strengthens from 0.9 euro/ dollar at E 0 to 1.05 euros/dollar at E 1 .

A stronger exchange rate, of course, makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results. Thus, a budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit.

You can also imagine this appreciation of the exchange rate as being driven by interest rates. As explained earlier in Budget Deficits and Interest Rates in Fiscal Policy, Investment, and Economic Growth , a budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. The depreciation of the U.S. dollar leads to a larger trade deficit (or reduced surplus). The connections between inflows of foreign investment capital, interest rates, and exchange rates are all just different ways of drawing the same economic connections: a larger budget deficit can result in a larger trade deficit, although the connection should not be expected to be one-to-one.

Questions & Answers

what determined how household and individual spending their budget?
isah Reply
what is economic as science
Adom Reply
What are considered as unlimited and insatiable in economics?
Benedict Reply
Dis my question Josef schumpeter defines Entrepreneurship as?...innovation process where a prospective individual creates something new?. a) what are the new things often created by the Entrepreneur? b) what are the four kinds of innovation emphasized in the definition?
Josephine Reply
what is complementary goods?
kwesi Reply
demands for one goods generates demand for other goods is called complementory goods.For Example coffee and sugar.
Rambharosh
It means you have to purchase sugar also if you purchase coffee.
Rambharosh
What is deflation
Aluko Reply
I don't know
Olaitan
decrease the price of commdity.
Seven
Deflation is the process where by communities offered for sale are more than the purchasing power, thus money available to buy.
Dwamena
Enumerate emotional intelligence to a manager
Chinonso Reply
What about Sydney Alexander's Absorption approach in international trade?
Vibhas Reply
I need help in inflation graphs
Brandon Reply
Select inflation type, Demand pull, cost pull or anticipation 1- Select the set of data you intend on graphing i.e inflation rate of 2017, location (particular country) 2 - Select the type of measurement tool that best allows you to input the inflation data, Consumer price index is the most accurate
Jama
this is to make sure you have all the correct information, Also use should know 1- Cost pull is Aggregate Demand and Aggregate Supply AD - AS graphed 2- Demans pull is Aggregate Supply and Aggregate Demand AS - AD graphed
Jama
what are costs of inflation ?
Rambharosh
what is production
Imoro Reply
please does anyone know anything about entrepreneurship
Josephine
anyone... please help me out
Josephine
Dis my question Josef schumpeter defines Entrepreneurship as“...innovation process where a prospective individual creates something new”. a) what are the new things often created by the Entrepreneur? b) what are the four kinds of innovation emphasized in the definition?
Josephine
Entrepreneurship The talent, knowledge and willingness to engage in New activities, especially that those that may result in New kinds of firm.
Angela
OK... thanks @Angela Ikanau
Josephine
please help me with my question
Josephine
Entrepreneurship can also be, The ability and willingness to undertake the organization and management of production. As well as making the usual business decisions , entrepreneurship is also associated with functions of innovative and bearing risks.
Angela
Production is the process by which human labour or work is applied, usually with the help of tools and other forms of capital to produce useful goods and services.
Angela
The new things often created by an entrepreneur are management skills,risk bearing, self motivation, passion, how to increase sales, minimization, profit maximisation, general administration and welfare of the business
Ademola
thank you @Ademola Omotolany
Josephine
Schumpeter identifies following five types of innovations that define the entrepreneurial act (note: the bold heading is mine). 1. Product: The introduction of a new good – that is one with which consumers are not yet familiar – or of a new quality of a good.
Ademola
2. Process: The introduction of a new method of production, that is one not yet tested by experience in the branch of manufacture concerned.
Ademola
3. Business model : The opening of a new market, that is a market into which the particular branch of manufacture of the country of question has not previously entered, whether or not this market existed before.
Ademola
4. Source of supply : The conquest of a new source of supply of raw materials of half manufactured goods, again irrespective of whether this source already exists or it has first to be created.
Ademola
5. Mergers & divestments: The carrying out of the new organization of any industry, like the creation of a monopoly position (for example through trustification) or the breaking up of a monopoly position.
Ademola
Awww thanks you so much @Ademola Omotolany
Josephine
production is the transformation of existing resources into new products or services
Samuel
Entrepreneur is the human factor that provides the capital for the business, takes the major decisions and bears the risk of the business
Samuel
l respect the intelligency of the people of this group. please I need thorough explanation of the word " cetri paribus"
olasupo
@olasupo "cetri paribus" is a latin word and it means "all other thing being equal"
Rambharosh
Thanks Yadav, that "all things being equal" is what I need explanation on because I assume is not possible to equate all things
olasupo
it is just for assumption
Rambharosh
Alright thanks
olasupo
Since economics deal with people who can alter things at any time in other to agree on certain theories there is the need to hold some actors constant
Ntui
Do you mean "ceteris paribus"? if so Latin phrase meaning approximately, "holding other things constant" used as shorthand for indicating the effect of one economic variable on another, holding constant all other variable that may affect the second variable. Contrast with mutatis mutandis.
Angela
That's mean we don't consider the other variables, we focus on the determinant variable So if we are in the market 1 we negligee the other markets markets. Another example, when we are studying the demand we focus just on the price without considering the other variables
Le
what is a monopolistic competition?
moniman Reply
Enumerate emotional intelligence to a manager
Chinonso
Enumerate emotional intelligence to a manager
Chinonso
who is barter
Tening Reply
exchange goods each other
Seven
what is economic
Bah
is the use of scares resources to satisfy our unlimited needs and wants
Desiderius
how many kinds of utility functions?
Sadaf
What is partnership?
Jackson
the legal association of two or more people as co-owners of a business for profit.
harmony
Would you expect the kinked demand curve to be more extreme (like a right angle) or less extreme (like a normal demand curve) if each firm in the cartel produces a near-identical product like OPEC and petroleum? What if each firm produces a somewhat different product?
James Reply
no
Sadaf
what is supply
Mizta Reply
what is opportunity cost
Mizta
The opportunity gained interms of opportunity lost is known as opportunity cost Or The second best alternative use of resources
Mir
forgone alternative: like forgoing Something our of two to buy one
Tam-Waribo
what is macro economic s
Addo Reply
macroeconomics is the study of economic as a whole level.
Gafar

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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