If a government started with a deficit and moved to a surplus, which statement would best describe 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

A government moving from a deficit to a surplus means that it is reducing its borrowing and paying back its debt. This reduces the demand for domestic savings and decreases interest rates. As a result, domestic investment would rise. However, a decrease in borrowing also means there is less demand for the domestic currency, causing it to depreciate and making the real exchange rate fall. Therefore, the best description of the effects of changing from a deficit to a surplus is that domestic investment would rise, and the real exchange rate would fall.

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