In an open economy, a government budget deficit raises real interest rates, crowds out domestic investment, causes the currency to appreciate and pushes the trade balance towards deficit.

Question

Quizplus · Accepted Answer

A government budget deficit leads to an increase in demand for loanable funds, which raises real interest rates, reduces domestic investment as resources are diverted towards government borrowing, and leads to an appreciation of the exchange rate as foreign investors move funds to take advantage of higher returns. The higher exchange rate makes exports relatively more expensive and imports cheaper, resulting in a deterioration of the trade balance.

In an Open Economy, a Government Budget Deficit Raises Real