Consider an economy initially in equilibrium with neither a trade deficit nor a government deficit. If taxes were cut without a corresponding reduction in government spending, you should expect to see
A) higher interest rates.
B) an appreciated domestic currency.
C) a reduction in net exports.
D) both a trade deficit and a government deficit.
E) all of the above.

Question

Quizplus · Accepted Answer

When taxes are cut without a reduction in government spending, the government deficit increases because the government is earning less from taxes but not reducing its expenditures. This increase in the deficit tends to push up interest rates as the government borrows more to finance its deficit. Higher interest rates can attract foreign capital, leading to an appreciation of the domestic currency. An appreciated domestic currency makes exports more expensive and imports cheaper, which can reduce net exports, contributing to a trade deficit. Therefore, all of the mentioned effects (higher interest rates, an appreciated domestic currency, a reduction in net exports, and both a trade deficit and a government deficit) are expected outcomes.

Consider an Economy Initially in Equilibrium with Neither a Trade