If a government started with a deficit and moved to a surplus, which of the following best describes the effects of these changes?
A)Domestic investment and the real exchange rate would rise.
B)Domestic investment and the real exchange rate would fall.
C)Domestic investment would rise, and the real exchange rate would fall.
D)Domestic investment would fall, and the real exchange rate would rise.

Question

Quizplus · Accepted Answer

When a government moves from a deficit to a surplus, it implies that the government is spending less than it is earning. This will lead to a decrease in the demand for loanable funds, which will lead to a decrease in the interest rate, making it more attractive to invest. As a result, domestic investment would rise. However, the decrease in demand for foreign currency will lead to the appreciation of the domestic currency, making exports less competitive, leading to a fall in the real exchange rate. Therefore, the best choice is C.

If a Government Started with a Deficit and Moved to a Surplus