Question

Explain how a shift from a government budget deficit to a budget surplus might affect the exchange rate.

Short answer

When a government shifts from a budget deficit to a budget surplus, it reduces the need for borrowing and decreases the demand for government bonds, resulting in lower interest rates. Lower interest rates make domestic assets less attractive to foreign and domestic investors, leading to decreased demand and increased supply of the domestic currency in the foreign exchange market. Consequently, the exchange rate depreciates, affecting international trade and capital flows.

Step-by-step solution

Understanding Government Budget Deficit and Surplus

A government budget deficit occurs when the government's expenses exceed its revenue. To finance the deficit, the government usually borrows money by issuing bonds. Conversely, a budget surplus takes place when the government's revenue is higher than its expenses. In this case, the government can save the extra money or use it to pay off existing debt.

Analyzing the Effect of Budget Surplus on Interest Rate

When a government shifts from a budget deficit to a budget surplus, it reduces the need for borrowing. As a result, the demand for government bonds decreases. Consequently, bond prices increase, causing a decrease in interest rates. Lower interest rates lead to cheaper borrowing costs, which in turn promotes more investments in the economy.

Assessing the Impact of Interest Rate on Demand & Supply of Currency

Lower interest rates lead to two main effects on the demand and supply of a currency in the foreign exchange market. Firstly, lower interest rates make domestic assets less attractive to foreign investors. This results in a decrease in demand for the domestic currency as foreign investors prefer investments with higher returns. Secondly, domestic investors will also look for higher returns, leading them to invest in foreign assets. This increases the supply of the domestic currency in the foreign exchange market, as they exchange it for foreign currencies.

Understanding the Effect on Exchange Rate

The decrease in demand for the domestic currency and the increase in its supply due to lower interest rates cause the exchange rate to depreciate. A depreciation of the domestic currency means that it has become less valuable in comparison to other currencies. This alteration in the exchange rate can affect international trade as well as capital flows between countries.

Conclusion

A shift from a government budget deficit to a budget surplus can affect the exchange rate through the following sequence of events: A budget surplus reduces the need for government borrowing, leading to a decrease in interest rates. Lower interest rates make domestic assets less attractive to both foreign and domestic investors, leading to a decrease in demand and an increase in the supply of the domestic currency in the foreign exchange market. As a result, the domestic currency depreciates, affecting international trade and capital flows.