Question #43
Reading: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value
PDF File: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value.pdf
Page: 17
Status: Unattempted
Correct Answer: B
Question
Country P has high capital mobility and has recently switched from balanced fiscal policy to an expansionary fiscal policy. Over time this expansionary is expected to lead to an increase in government debt to GDP ratio. If we simultaneously consider both the Mundell-Fleming and the portfolio balance model, in the long run country P's currency is most likely to:
Answer Choices:
A. appreciate
B. depreciate
C. remain stable
Explanation
Under the portfolio balance model, as the ratio of government debt to GDP increases over
time and the level of government debt becomes unsustainable, the currency of country P
should depreciate. (Under the Mundell-Fleming model, country P's currency should
appreciate in the short-term as fiscal deficits push interest rates higher, however this
question is specifically asking about the long-run effect).