If the U.S. government went from a budget deficit to a budget surplus then the real interest rate

Question

a. would decrease and the real exchange rate would increase.
b. would increase and the real exchange rate would decrease.
c. and the real exchange rate would decrease.
d. and the real exchange rate would increase.

Answer 1

When the U.S. government shifts from a budget deficit to a budget surplus, it generally means that the government is borrowing less or repaying some of its debt. This can reduce the demand for loanable funds, which puts downward pressure on real interest rates. As real interest rates decrease, it can lead to an appreciation of the currency due to reduced returns for foreign investors in U.S. assets, which might encourage capital outflow or reduce capital inflow.

However, the real exchange rate's movement can depend on various factors, including the international context and capital flows. Typically, if the government is running a surplus, this could lead to an increase in national savings, which might create downward pressure on domestic interest rates, leading to an appreciation of the currency comparatively.

Given these understandings, the correct answer to the question is:

a. would decrease and the real exchange rate would increase.

This means that as the government moves to a surplus, real interest rates decrease, and the value of the currency in real terms increases, reflecting a higher real exchange rate.