Exchange rate and trade balance

 Exchange Rates and the Trade Balance
As discussed above, fiscal stimulus can cause interest rates to rise. As domestic rates rise relative
to foreign rates, investors tend to seek out U.S. investments because the relatively high interest
rates mean relatively high returns on investment. However, as foreign capital flows into the
United States, this can push rates back down as the supply of loanable funds increases, potentially
offsetting the initial rise in rates caused by the stimulus.
Nonetheless, increased demand for U.S. investment from foreign investors also means that the
demand for the dollar would increase as foreign investors exchanged various foreign currencies
for dollars that they could then invest. This increased demand for dollars increases the value of
the dollar, referred to as appreciation. When the dollar appreciates it becomes more expensive
relative to other currencies—it takes more foreign currency to “purchase” one dollar—and,

 U.S. goods and services become more expensive relative to foreign goods and services,
causing exports to decrease and imports to increase. The end result is generally an increase in the
U.S. trade deficit, as exports decrease and imports from abroad increase in the United States. 9 An
increasing trade deficit, all else equal, means that consumption and production of domestic goods
and services are falling, partly offsetting the increase in aggregate demand caused by the
As discussed above, however, during a recession interest rates are less likely to rise, or are likely
to increase to a lesser degree, due to an already depressed demand for investment and spending
within the economy.10 Without rising interest rates, or if they increase to a lesser degree, the
associated increase in the trade deficit is also likely to be smaller. In addition, if the Federal
Reserve engages in similarly stimulative monetary policy, it may be able to mitigate some of the
anticipated increase in the trade deficit by further preventing an increase in interest rates.
The goal of fiscal stimulus is to increase aggregate demand within the economy. However, if
fiscal stimulus is applied too aggressively or is implemented when the economy is already
operating near full capacity, it can result in an unsustainably large demand for goods and services
that the economy is unable to supply. When the demand for goods and services is greater than the
available supply, prices tend to rise, a scenario known as inflation. A rising inflation rate can
introduce distortions into the economy and impose unnecessary costs on individuals and
businesses, although economists generally view low and stable inflation as a sign of a well-

8 For further information regarding monetary policy, see CRS Report RL30354, Monetary Policy and the Federal
Reserve: Current Policy and Conditions, by Marc Labonte.
9 Olivier Blanchard, Macroeconomics, 5th ed. (Upper Saddle River NJ: Pearson Education, 2009), pp. 450-451.
10 Auerbach and Gorodnichenko

, “Measuring the Output Responses to Fiscal Policy.”
11 For further information regarding monetary policy, see CRS Report RL30354, Monetary Policy and the Federal
Reserve: Current Policy and Conditions, by Marc Labonte.
Fiscal Policy: Economic Effects
Congressional Research Service 4
managed economy.12 As such, rising inflation rates can hinder the effectiveness of fiscal stimulus
on economic activity by imposing additional costs on individuals and interfering with the
efficient allocation of resources in the economy.
The Federal Reserve has some ability to limit inflation by implementing contractionary monetary
policy. If the Federal Reserve observes accelerating inflation as a result of additional fiscal
stimulus, it can counteract this by increasing interest rates. The rise in interest rates results in a
slowing of economic activity, neutralizing the fiscal stimulus, and may help to slow inflation as
Inflation has generally remained low despite relatively high deficit spending during the 11-year
expansion between the Great Recession and the current COVID-19-induced recession. This
indicates that in the near term, the size of this potential offsetting benefit could be relatively small
and even prove counter to the Federal Reserve’s monetary policy strategy of targeting an average
of 2% inflation over time.1

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