Why does expansionary fiscal policy lead to appreciation of domestic currency? If by reducing taxes, or increasing gov spending you are increasing money in the system …which will likely lead to inflation and a devaluation ?
I was asking myself the same question several hours ago :).
So the answer is- that’s true only under the Mundell-Fleming model which does not account for inflation. The logic is: expansionary fiscal policy leads to higher interest rates => higher capital inflows => currency appreciation.
It is confusing because there are other muddling effects as well. Expansionary fiscal policy heats up the economy. This increases consumption. This hurts the trade balance. That does devalue the currency.
However, you can generally assume the monetary policy effects will be greater. By having an expansionary fiscal policy, interest rates rise. Like Gebura said, this means higher capital inflows. The currency appreciates and this has a greater effect than the trade balance.
the key here is in the SHORT RUM, under expansionary fiscal, real interest rates will increase.
in the long run, it is inflationary, i think…
expansionary fiscal policy leads to higher interest rates - really? I dont’ think so. It’s definitely not correct in practice
Governments tend to use tax cuts and expanded governmental spending to drive an expansionary fiscal policy. This undermines the creditworthiness of the government (less cash inflows, more cash outflows). Therefore, buyers of that government’s debt demand higher interest rates.
It’s a simplification that doesn’t need to hold true in practice but that’s the idea.
Expansionary fiscal policy lead to currency appreciation, this is how it works
Expansionary fiscal policy is a result of budget deficit because the government expenditure is higher than its revenue collection so inorder fund its expenditure it has to go and borrow money so through borrowing money it leads to crowding effect which leads to increase in interest rate this will increase flow of capital and this will lead to increase in demand of local currency and the end result is currency appreciation
Of course it is.
Expansionary fiscal policy puts an upward pressure on domestic real interest rates.
In a free capital flowing economy, this increases the demand on the domestic currency, leading to appreciation. However, this is not sustainable as goverenments will either reverse the policy at some point, or break under a heavy debt load.
Inflation and money supply are not really relevant with the foreign exchange. At least on the short run.
Yes, this holds in a short run. In a long run we have the asset-based approach which states that after the initial appreciation, the currency will depreciate.
One: When US Fed wanted to stimulate the economy (i.e. expand) what did they do? Raise or lower?
Second: In the long run the you’re right - there’s an upward pressure on IR because of the side effects of sustained lowering of interest rates. In the short term, it’s very specific - in a country like, say, India - lowering rate is a good thiing and will lead to appreciation. In US, lowering rates would cause the dollar to tank. Look at Europe as an example.
We’re talking fiscal policy, sir.
damn, arghhh - time to take a nap!
That made me chuckle…I’m currently having this feeling about 10 times a day…and that’s going over stuff I should already know!!
Last night I felt fried all of a sudden during a derivatives subject test-- couldn’t calculate a swap or swaption all of a sudden … that’s when I called it a day