If a government increases its budget deficit, which statement would best predict the effects?
A) The real exchange rate and domestic investment rise.
B) The real exchange rate and domestic investment fall.
C) The real exchange rate rises, and domestic investment falls.
D) The real exchange rate falls, and domestic investment rises.

Question

Quizplus · Accepted Answer

When a government increases its budget deficit, it typically borrows more money, leading to an increase in the demand for loanable funds, which raises the interest rate. The higher interest rate makes domestic assets more attractive to foreign investors, increasing the demand for the domestic currency and causing its value to appreciate, as measured by the real exchange rate. This makes exports relatively more expensive and imports relatively cheaper, leading to a decrease in net exports. The decrease in net exports reduces aggregate demand and causes a fall in domestic investment.

If a Government Increases Its Budget Deficit, Which Statement Would