Question

Why will the large U.S deficit result in inlfation, assest bubbles, and a weaker dollar.

Answer 1

(1) Result on inflation:

Inflation is the steady increase in the general price over a period of time, usually one(1) year.

There can be two ways n which inflation is experienced in an economy, being the cost push (where companies, producers experience high production costs and thus increase the selling price) and demand pull (where an increased rate of income causes a further increase in the demand of goods and services, at constant supply).

Government budget deficit occurs the government expenditure exceeds the government revenue.

When the government revenue is under pressure, the government will make use of their Fiscal policy measures to counteract the deficit through tax rates increase. Tax being the main government revenue stream.

The supply side of the economy, producers, experience an increased cost through increased taxes, this makes producing difficult, the producer, does not incur the cost alone, it is passed to the consumer by adding the increased average cost into the selling price, thus the increase in the general price occurring.

(2) Asset Bubbles:

An asset bubble is when the price of an asset, such as housing, stocks or ?gold, become over-inflated. Prices rise quickly over a short period. They are not supported by an underlying demand for the product itself. It's a bubble when investors bid up the price beyond any real sustainable value. These price spikes often occur when investors all flock to a particular asset class, such as the stock market, real estate or commodities.

Low interest rates are the most frequent cause of an asset bubble. They create an over-expansion of the money supply. Hence, investors can borrow cheaply but cannot receive a good return on their bonds. Therefore, they look for another asset class.

The second biggest cause is demand-pull inflation. That's when an asset class suddenly becomes popular. As asset prices rise, everyone wants to get in on the profits. But the consumer price index does not always accurately capture this form of inflation. Therefore, policy-makers overlook it.

Third, a supply shortage will aggravate an asset bubble. That's when investors think that there is not enough of the asset to go around. They panic, and start buying more before it runs out.

(3) Weaker Dollar:

For the trade deficit to turn into a surplus, imports must fall and exports must rise. One way this adjustment can take place is if the dollar depreciates, making imports more expensive for Americans and exports cheaper for foreigners. If trade deficits are sufficiently large and unsustainable, economists believe that they will be associated with a weakening dollar at some future date.

The U.S. economy has been doing very well for many years now, making it an attractive place for foreigners to invest in. As a result, they have been willing to finance growing U.S. trade deficits in the 1990s. While the deficits have reached unprecedented levels, the dollar has shown no consistent signs of weakening over this decade. Thus, trade deficits can be sustainable for a very long time, making the short run relationship between trade deficits and the dollar very tenuous.

To conclude, in the long run, trade deficits may be expected to contribute to a weaker dollar, as the economy adjusts to create the surpluses needed to repay foreign investors. However, in the short run, the relationship between the trade deficit and the dollar is weak, and the value of the dollar is determined largely by investor preferences for U.S. dollar assets.