If a government increases its budget deficit, which statement would best predict the effects?
A) The real exchange rate appreciates, and the trade balance moves toward surplus.
B) The real exchange rate appreciates, and the trade balance moves toward deficit.
C) The real exchange rate depreciates, and the trade balance moves toward surplus.
D) The real exchange rate depreciates, and the trade balance moves toward deficit.

Question

Quizplus · Accepted Answer

When a government increases its budget deficit, typically by either increasing government spending or cutting taxes, it tends to lead to higher domestic interest rates to finance the deficit. Higher interest rates attract foreign capital, leading to an appreciation of the real exchange rate. An appreciated currency makes domestic goods more expensive relative to foreign goods, reducing exports and increasing imports, which moves the trade balance toward a deficit.

If a Government Increases Its Budget Deficit, Which Statement Would