The Portfolio Balance Approach

When a government spends more money, a lot of things can happen.

Expansionary fiscal policies stimulate aggregate demand and make people feel wealthier today, leading them to purchase more foreign goods. What effect do you think this has on the exchange rate?

Not exactly. Consider what is necessary in order for the local population to consume more foreign goods.

That's right! The increased consumption of foreign goods is paid for (somewhere along the line) by exchanging the domestic currency for foreign currency. This _weakens_ the domestic currency.

No. Consumers are purchasing more foreign goods, which must ultimately be paid for in foreign currency.

Of course, when government spends more or taxes less, the budget surplus falls, or the deficit grows. Either way, the government will need to do more net borrowing in the markets. As the government demands more money, the price of money changes. What effect do you think this has on the exchange rate?

Actually, this _will_ have an effect in the money market. Recall that the price of money is the interest rate.

That's not right. This added borrowing will serve to raise interest rates; consider what, if any, effect this will have on the value of the domestic currency.

Exactly! This is commonly called the "crowding-out effect." Government decides to be expansionary by taxing less or spending more, and it borrows money in order to do it. This raises the interest rate, which by itself is not expansionary. So as government "crowds out" other investment, the higher interest rates cause capital inflows from other nations. These inflows apply upward pressure on the value of the domestic currency.

So the effect of fiscal policy on exchange rates is ambiguous. It depends on what force is strongest. Still, even if the extra spending does bring in more capital in the short run, that debt has to be taken care of eventually. A government could simply pay it back with surpluses later, or it could default, or it could monetize the debt by having the central bank purchase it. What method do you think would cause a currency depreciation?

Yes. In fact, all of these are correct. Default will cause a rapid loss in currency value, as history has shown. Budget surpluses are the opposite of the budget deficits that caused the potential appreciation in the first place via the interest rate; surpluses (generated from reduced spending or higher taxation) will lead to excess capital and lower interest rates, causing a capital flight and a lower currency value. Debt monetization is basically repaying the debt with freshly printed domestic currency, which will cause inflation and loss of purchasing power.

A couple of old ideas can come together here. The Mundell-Fleming model can show why fiscal policy might be a net positive to the currency in the short run, as long as there's no expansionary monetary policy to cancel out the crowding-out effect. This __portfolio balance approach__ suggests that foreign entities are willing to hold only so much debt before they decide to sell, which will cause a currency depreciation in the long term. And again, it really doesn't matter what the country decides to do once that questionable debt level is reached. If it does too much spending, there's no way out; its currency is eventually going down.

To summarize: [[summary]]

There would be little to no effect

The domestic currency would weaken

The domestic currency would strengthen

There would be little to no effect

The domestic currency would weaken

The domestic currency would strengthen

Default

Budget surpluses

Debt monetization

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