Question

Suppose a country was facing the problem of budget deficit and by reducing government expenditures the government has achieved the target of balanced budget.

With the help of appropriate diagrams explain how a country’s shift from budget deficit to balanced budget would affect its investments, economic growth, net capital outflow and currency exchange rate

Answer 1

Ans. A reduction in budget deficit is decrease in government spending. It leads to decrease in consumption leading to decrease in transaction demand for money shifting the money demand curve leftwards from Md to Md'  which causes the interest rate to fall from r to r'.
This decrease in interest rate causes cost of borrowing to decrease increasing investment spending
Also, this decrease in interest rate makes it less attractive for foreign investors to invest in the home country due to low rateof return. This increases net capital outflow. Increase in net capital outflow decreases demand for domestic currency (or increase in demand for foreign currency shifting the demand curve to the right form D to D')leading to its depreciation (i.e. increase in exchange rate from e to e') which makes the exports cheaper to foreign countries but imports to home country becomes expensive leading to decrease in demand for imports and increasing the demand for exports increasing net exports.

This increase in investment spending and net exports increases aggregate demand for goods but decrease in government spending and consumption spending decreases the aggregate demand for goods but the net effect will be decrease in aggregate demand because of the size of consumption expenditure is larger in aggregate demand as compared to any other components. This shifts the aggregate demand curve to the left from AD to AD' decreasing the price level from P to P' and real output from Y to Y'.

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