I’m doing this post to make the connection between economic theory and real economic events.
The US Dollar has appreciated sharply post Donald Trump’s unexpected electoral win on Nov 8th, 2016 (See chart below). Let’s understand why this has happened.
USD - INR Exchange Rate
Source: www.investing.com
Trump has promised higher spending on infrastructure.
“We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it."
This excerpt is right out of his President-elect acceptance speech. Heavy infrastructure spending is a pretty un-Republican promise by the way....but I digress.
He’s also promised tax cuts. Higher government spending (G) coupled with a cut in taxes (T) implies a higher budget deficit (T - G).
How does this impact the dollar?
Let’s bring in the theory here.
Per theory, the US corresponds to the case of the “Large Open economy”. It’s “Open” because it freely conducts trade with the ROW and “Large” because it is big enough to impact the “world interest rate” i.e. the general level of interest rates prevailing across the globe (with all the variations across countries given domestic policy actions, capital immobility etc.).
We know that for any nation, S - I = NX
Or S = I + NX - (1)
Where S = Saving, I = Investment, NX = Net Exports, and S - I = CF (Net Capital Outflow)
For those of you who are unaware of this identity, please read my post Why are the Net Exports of a Country = its Net Capital Outflow?, where I explain the fundamental logic behind this truism.
Now let’s see what happens when the US increases Government Spending (G) and cuts Taxes (T)
Let’s start with the National Income Identity
Y = C + I + G + NX
Where C = consumption and I = Investment
Note: C is further = c (Y - T), where “c” is a constant called the “Propensity to Consume”, and (Y - T) or Income minus taxes gives us the “Disposable Income” with households.
“I” is a function of the interest rate “r”, and hence is better expressed as I (r). The higher the interest rate, lower the investment spending.
Lets now rewrite the National Income Identity:
Y = c (Y - T) + I (r) + G + NX
Moving things around, we get:
Y - c (Y - T) - G = I (r) + NX - (2)
Note, Y - C - G = S (Savings)
Substituting this on the LHS in (2) gives us S = I (r) + NX, as we had noted in (1) above.
If the US increases G and cuts T (look at eq. 2), S (Savings) will fall.
What happens in the Loanable funds market when Savings fall?
In the loanable funds market, the Supply of funds = S (Savings), and the demand for funds = I + CF (Investment + Capital outflow).
In a large open economy like the US, not only Investment (I), Capital Outflow (CF) depends on the domestic interest rate (r) as well. The higher the “r”, the lower the CF because if there are high interest yielding domestic investment opportunities, capital will not flow abroad as much.
The market reaches equilibrium through the interest rate mechanism when supply of funds = demand for funds or S = I (r) + CF (r).
Look at the Market for Loanable Funds in Chart 1 below. When Savings fall (due to an increase in G and/or a fall in T), the supply of funds falls from S1 to S2. As a result, the equilibrium in the loanable funds market moves from E1 to E2 and the interest rate moves higher from r1 to r2.
Chart 1: What happens to Savings, Net Capital Outflows and Net Exports when Government Spending is hiked and Taxes are cut
What happens to Net Capital Outflow?
At the new equilibrium E2, I and CF are both lower and “r” is higher (r = r2). How much lower is CF exactly? Look at the Net Capital Outflow section in Chart 1 above. At r2, CF = CF2 (vs. CF1 at r1).
Note: For the US, Net Capital Outflow (CF) is negative i.e. foreign funds are flowing into the US on a net basis (there are net capital inflows). To capture this reality, in the Net Capital Outflow sub-chart above, I’ve shown the CF vs. interest rate (r) graph for the US in the negative region of the x-axis i.e. where CF < 0 (the capital inflow region).
When the interest rate in the US rises from r1 to r2, net capital outflows fall from CF1 to CF2. In the case of the US, this means its net capital inflows rise from -CF1 to -CF2 (net capital inflows rise in absolute terms).
What happens to the Exchange Rate and to Net Exports?
When the interest rate rises from r1 to r2 and net capital inflows into the US rise from -CF1 to -CF2, the demand for US dollars (USD) increases. Why? Because when foreign funds flow into the US, they have to convert their currency into USD in order to invest in the American market. So they demand USD. When the demand for USD increases, the dollar appreciates i.e. its real exchange rate vs. other currencies rises (you can buy more foreign goods in exchange for 1 American good). When the dollar appreciates, USA’s exports become more expensive for foreigners and imports become cheaper for the US. This leads to a net increase in imports i.e. a widening of the US trade deficit. (The US has been running a Trade Deficit for decades).
You can see this in the “Net Exports” portion of Chart 1. When Net Capital Inflows rise from -CF1 to -CF2, the Real Exchange Rate for the USD rises from ᙓ1 to ᙓ2, which causes Net imports to rise from -CF1 to -CF2 as well.
I’m going to explain this same thing in a simpler way.
I’ve explained why Net Exports are = Net Capital Outflows in my post by the same title, Why are the Net Exports of a Country = its Net Capital Outflow?. Here, we'll further refine that understanding.
When foreign funds flow into the US, they demand USD for investment purposes. Infact, Net Capital Inflows into the US are the source of demand for USD in the forex market.
USA’s net imports (America has been a net importer for decades) are the source of supply of USD in the forex market because when America buys foreign goods, it pays for them in USD (most trade transactions across the globe are denominated in USD).
How does the demand for USD (capital inflows) and the supply of USD (net imports) reach equilibrium? Through movements in the real exchange rate for the USD. The real USD exchange rate (vs. other currencies) moves up or down until the demand for USD = the supply of USD i.e. Net Capital Inflows into the US are = America’s net imports. The exchange rate mechanism ensures this.
To Conclude...
...It's now clear why Trump’s promises to hike spending and cut taxes have led the USD to appreciate vs. other currencies post his election victory. The USD is moving exactly as it should theoretically in anticipation of Trump’s fiscal moves.
