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How might a budget deficit affect the balance of trade?
a. A budget deficit reduces interest rates, which reduces exchange rates and reduces the balance of trade.
b. A budget deficit raises interest rates, which raises exchange rates, and increases the balance of trade.
c. A budget deficit raises interest rates, which raises exchange rates, and reduces the balance of trade.
d. A budget deficit reduces interest rates, which raises exchange rates, and reduces the balance of trade.
- 9 years agoFavorite Answer
■A budget deficit raises interest rates, which raises exchange rates, and reduces the balance of trade.
A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate. The higher interest rate reduces net capital outflow, which reduces the supply of dollars in the market for foreign-currency exchange. The dollar appreciates, and net exports fall.
The adverse consequences of sustained large budget deficits may well be far larger and occur more suddenly than traditional analysis suggests, however. Substantial deficits projected far into the future can cause a fundamental shift in market expectations and a related loss of confidence both at home and abroad. The unfavorable dynamic effects that could ensue are largely if not entirely excluded from the conventional analysis of budget deficits. This omission is understandable and appropriate in the context of deficits that are small and temporary; it is increasingly untenable, however, in an environment with deficits that are large and permanent. Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy:
•As traders, investors, and creditors become increasingly concerned that the government would resort to high inflation to reduce the real value of government debt or that a fiscal deadlock with unpredictable consequences would arise, investor confidence may be severely undermined;
•The fiscal and current account imbalances may also cause a loss of confidence among participants in foreign exchange markets and in international credit markets, as participants in those markets become alarmed not only by the ongoing budget deficits but also by related large current account deficits;
•The loss of investor and creditor confidence, both at home and abroad, may cause investors and creditors to reallocate funds away from dollar-based investments, causing a depreciation of the exchange rate, and to demand sharply higher interest rates on U.S. government debt;
•The increase of interest rates, depreciation of the exchange rate, and decline in confidence can reduce stock prices and household wealth, raise the costs of financing to business, and reduce private-sector domestic spending;
•The disruptions to financial markets may impede the intermediation between lenders and borrowers that is vital to modern economies, as long-maturity credit markets witness potentially substantial increases in interest rates and become relatively illiquid, and the reduction in asset prices adversely affects the balance sheets of banks and other financial intermediaries;
•The inability of the federal government to restore fiscal balance may directly reduce business and consumer confidence, as the view of the ongoing deficits as a symbol of the nation's inability to address its economic problems permeates society, and the reduction in confidence can discourage investment and real economic activity;
• These various effects can feed on each other to create a mutually reinforcing cycle; for example, increased interest rates and diminished economic activity may further worsen the fiscal imbalance, which can then cause a further loss of confidence and potentially spark another round of negative feedback effects.
Although it is impossible to know at what point market expectations about the nation's large projected fiscal imbalance could trigger these types of dynamics, the harmful impacts on the economy, once these effects were in motion, would substantially magnify the costs associated with any given underlying budget deficit and depress economic activity much more than the conventional analysis would suggest. Indeed, the potential costs and fallout from such fiscal and financial disarray provide perhaps the strongest motivation for avoiding substantial, ongoing budget deficits.