In an open economy, governments running a budget deficit will experience what effect on their domestic money supply (first response) and also the value of their currency in the FOREX market (second response)?
Options:
- increase / appreciate
- decrease / depreciate
- no effect / depreciate
- increase / depreciate
- decrease / appreciate
Answer (2)
When a government runs a budget deficit, it typically experiences an increase in the domestic money supply due to financing by borrowing. However, this can lead to a depreciation of its currency in the FOREX market due to inflationary pressures. Thus, the correct option is 'increase / depreciate.'
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In an open economy, a government running a budget deficit can have significant effects on both the domestic money supply and the value of its currency in the foreign exchange (FOREX) market.
Effect on Domestic Money Supply:
When a government runs a budget deficit, it means that its spending exceeds its revenue. To finance this deficit, the government might borrow money. In an open economy, this borrowing often leads to an increase in the domestic money supply. This is because the government might issue more bonds, which are bought by the central bank or the public, effectively injecting more money into the economy. Therefore, the first response is an "increase" in the domestic money supply.
Effect on Currency Value in the FOREX Market:
The value of a currency in the FOREX market is influenced by supply and demand dynamics. A government running a deficit may need to borrow from foreign investors, leading to an increased supply of the domestic currency in global markets. Additionally, if investors perceive the deficit as a sign of potential inflation or economic instability, they may demand less of the country's currency. As a result, the currency might "depreciate."
Consequently, the combination of these effects results in the answer: increase / depreciate .
Therefore, in an open economy, a government running a budget deficit will likely experience an increase in the domestic money supply and a depreciation in the value of its currency in the FOREX market. This analysis provides insight into the intricate relationship between government fiscal policies and their broader economic impacts.
