Question

Explain how government budget deficits impact the exchange rate and the flow of capital in the United States.

Answer 1

• Govt's Budget is in deficit when the receipts are less and there is high govt spending (i.e expenditure exceeds receipts).
• A high budget deficit means the govt is puuting more money in the hands of public which leads to increase in demand (due to more income) of both domestic goods and the imported goods. Now the imports rise and exports are constant , this creates a situation of trade deficit where imports exports causing a net outflow of capital .
• This means foreign countries now hold more dollars (due to outflow of capital to foreign countries) .
• Now these dollar holdings by foreign investors will be used to buy govt bonds in U.S and this will result in inflow of capital in form of investment further used to fund the deficit.
• THERE will be more demand for dollars for the investment purpose.
• This will increase the demand for dollars in the foreign exchange market whereas the supply will decrease because they(investors) will not supply with all the dollars quantity they possess(because they keep some for future) .
• This increase in demand of the dollar and decrease in supply of dollar causes APPRECIATION of exchange rate.
• This happens only when the exchange rate of country is strong.