Question

How can increased government budget deficits potentially impact currency value? Illustrate the effects using a Foreign Exchange Market diagram and consider the following two scenarios:

1. The likelihood of government defaulting on its debt obligation is low
2. The amount of national debt is very high relative to GDP and is perceived to be unsustainable

Answer 1

One way of thinking about a budget deficit is that if the government is borrowing from the private sector, the private sector has lower funds to spend and invest. The government is therefore ‘crowding out’ the private sector – and some economists will argue government spending is liable to be more inefficient than the private sector
Budget deficits have potential economic costs, but it depends on the economic climate, the exchange rate system, interest rates and the reason for government borrowing.
Higher deficits are not sustainable for ever. Reducing a budget deficit can be problematic. If a country has a deficit that increases too quickly, the government may be forced to adapt policies aimed at a sharp deficit reduction. These ‘austerity measures’ can cause a fall in aggregate demand. For example, during 2012-18, many countries in the Eurozone sought to reduce their budget deficit to comply with EU rules. This deficit reduction caused lower growth, recession and unemployment.
A budget deficit increases the level of public sector debt. Large deficits will cause national debt as a % of GDP to increase.
if the deficit occurs during a period of strong economic growth, then the government deficit will be crowding out the private sector. Government borrowing will reduce private sector investment and spending, and you could argue the government spending is more inefficient than the private sector.
If the government borrowed to invest in improving infrastructure, it might be able to overcome market failure and improve the productive capacity of the economy. The return from public sector investment may be greater than the cost of borrowing, and so in the long-term the economy benefits from government borrowing and investment