CFA Practice Question

CFA Practice Question

Budget and trade deficits are linked because ______
A. if the government borrows more and interest rates rise, people save more and reduce consumption. This leads to a lowering of demand and prices fall, which makes imports more expensive; the trade deficit narrows.
B. if the fiscal deficit is financed by borrowing from foreigners, the borrowing country's currency would appreciate, leading to rising imports and higher trade deficits.
C. as the government spends and inflates the economy, its currency depreciates and exports rise, creating a trade surplus.
Explanation: This is driven by the crowding-out model and is presented as one of two scenarios in the reading. The trade and fiscal deficits are linked if the government resorts to borrowing from foreigners.

User Contributed Comments 8

User Comment
george2006 It is hard for me to understand how the borrowing country's currency would appreciate when it fianced its fiscal deficit by borrowing from foreigners.

Trying to make it work by thinking: in order to lend dollar to the US, foreigners have to obtain dollars from the market, which would drive up the demand for the dollar and its price in the market.
jayjunk This actually happened in the 1980s when high US interest rates caused larger demand for dollars, causing it to appreciate and also making imports cheaper.
MUSK first you borrow, then you need to convert into domestic currency for ur domestic use, in this process u sell the foreign currency and buy domestic currency resulting in appreciation of DC
mirco Fiscal deficit -> govt. borrows more -> interest rates increase -> fund inflow -> currency appreciates -> exports decrease, imports increase
capitalpirate the inverse: US goct increases spending printing notes, currency depreciates as supply increases.
to counter this depreciation, it borrows from abroad, further increasing spending! until its debt soars, as it is now!
then cut rates, further depreciation... then tax rebates!!! all the ingredients for being doomed!
solonzo fiscal deficit means lesser tax on goods,making import attractive and higher trade deficit because export is lesser than import(BOP)
cong B is correct. Increasing borrowing from foreign countries increases the demand of domestic currency in the Forex market, hence the appreciation of domestic currency.
cardinal08 In such a sepcific situation - It is important to treat a deficit financed by foreigners like an increase in foreign demand of a domestic good. Demand for domestic currency increases, appreciating its value and increasing the trade deficit of the borrowing country. This seems to be as far as the CFA goes - If you begin to think about the international debt markets- where a country goes to finance its deficit, this relationship becomes complicated by sometimes competing moving parts in the model. Namely, the sustainability of the rest of the world to continue to demand the borrowing countries debt - which eventually might lead to currency depreciation - see Greece today.
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