if we are fiscally restrictive & there is high cap mobility then the currency should depreciate…why? the way I remember it is if we are fiscally restrictive, we are taxing more and spending less and probably paying down government debt which decreases the total number of bills in the economy and therefore each one is worth less? is this good logic?
It’s my understanding that when we have the opposite (i.e. an expansive fiscal policy) there’s more money in the economy, which puts upward pressure on the interest rate (to try to reign in inflation) which makes foreign investors pour in, which makes the currency appreciate. I’m guessing restrictive fiscal policy has the opposite logic.
It is really common that public investments (and maybe public expenses as well) be financed by government debt in national currency.
So, in an expansionary fiscal policy , the government will issue new bonds at lower prices because investors will ask higher compensation (higher interest rate) for the higher risk they are bearing. Higher risk because the government is increasing national debt…, it will also depend the fiscal budget balance of course. If the budget balance is really good (superavit) the new rates probably will be similar of market rates, otherwise they will be higher.
In a restrictive fiscal policy , the government will cut bond issuances and the current gov bonds in market will gain valor as they are more scarce (remember gov bonds are very liquid so easily impacted by this type of policies). Higher prices of national bonds mean lower implied interest rates.
You can think about gov bond issuance as a money suck from the market because private sector will buy the bonds and hence retire their money from the system to lend it to the treasury. So lower quantity of money in the market provokes higher interest rates. When gov bond issuances are cut, then there is a higher quantity of money in the market, hence lower interest rates.
We know what happen to interest rates at each policy so far. Now extend the analysis to exchange rates assuming high capital mobility. In a restrictive fiscal policy, interest rate will be lower. As there is high capital mobility, investors will consider the local instruments a bad investment choice, so they will prefer to invest abroad. In the process, the quantity of foreign currency in the market will decrease (as they are moved to other countries to buy investment instruments there), so in relative terms there is more local currency than foreign currency than before. _ The local currency depreciates. _
Any question please ask!
There will be less money in the market indeed, because private sector will use their money to buy new gov bonds. This will pressure interest rate upward. Remember the law of supply and demand, the lower the quantity of something, the higher its price.
This is correct.