Question

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

Short answer

The trade deficit will reduce as the government relies less on foreign investment, and the exchange rate will devalue.

Step-by-step solution

Definition

The budget of the government can tell us if the government is following an expansionary or contractionary fiscal strategy. This is because the budget reveals whether the government intends to increase spending on the economy or reduce it through taxation.

Explanation

As the government relies less on foreign investment, the trade imbalance will shrink, and the currency rate will depreciate. The investment will rise if government policy switches from a budget deficit to a budget surplus while the trade deficit remains stable. In times of economic boom, higher tax income, lower unemployment rates, and increased economic growth reduce the need for government-funded programs, hence budget deficits as a percentage of GDP may drop.