Principles of Macroeconomics / Unit 15 MAC 1410 worked example, 60 to 90 seconds
Tracing the Chain Through the Exchange Rate
The idea
Tell the budget-to-trade story a second way, through unit thirteen's market, and check that both routes give the same answer. Government borrowing raises the domestic interest rate; higher returns attract foreign funds; the currency appreciates; and an appreciated currency widens the trade deficit.
In practice
The interest rate rises from 5 to 6 percent. Foreign investors want domestic assets, so demand for the currency rises while domestic holders supply less of it. Both shifts push the same way and the currency appreciates from 10 pesos per dollar to 11. Now apply unit thirteen's result: domestic exports cost foreign buyers more, so exports fall, and imports cost domestic buyers less, so imports rise. Net exports fall and the trade deficit widens. The identity said the trade term could absorb the borrowing; this is the mechanism by which it does.
Where people slip
The two routes are one process seen twice, not two effects to be added. Adding them would double-count. The spending route and the exchange-rate route describe the same funds arriving from abroad, and unit thirteen's warning applies here too: when both currency curves shift the same way the direction is certain and the quantity is not.
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