Question

If the USA continues to increase its federal budget deficit, what effect will this have on the U.S. dollar and why? What will be the effect on the balance of trade and why? Explain.

Answer 1

It all depends on what drives the U.S. current-account deficit upward. If the deficit increases due to the strong growth of the U.S. economy, the dollar is likely to rise in value as foreign capital comes to take advantage of opportunities for growth. On the other hand, if the current-account deficit increases because of the increasing government budget deficit, then the dollar's value is likely to decline due to the adverse effects of the abudget deficit on future economic growth. As the exchange rate is set at too high a level, the current-account deficit could also increase. If so, then the future prospects for the dollar would also be dim.

Similarly, if the U.S. current-account deficit increases because foreign central banks intervene to hold down their currency values, sooner or later the U.S. dollar should fall.

As the dollar is rising in value, other things being equal, U.S. goods and services are becoming relatively more expensive in terms of foreign currency, while foreign goods and services are becoming relatively less expensive in terms of dollars. Of course, this conclusion could be reversed if a significant increase in U.S. productivity, which would facilitate exports, were thereason for the increase in the real value of the dollar. Other things still aren't equal, though. Currency supplies and demands are in fact equated with exchange rates.

They do not determine how these currency flows are distributed between trade flows (the current-account balance) and capital flows (the balance of financial accounts). This view of exchange rates predicts that between the exchange rate and the current-account balance there is no simple relation. Trade deficits do not cause currency depreciation, nor does currency depreciation help to reduce a trade deficit by itself: more fundamental economic factors define both exchange rate changes and trade balances.