3.2 Exchange Rate

A cut in government spending also has effects on the exchange rate of the home currency, because of the fall in interest rates. The lower interest rates lead to a decrease in demand of the currency, which in turn leads to depreciation. A depreciated currency means that the goods of the home country become cheaper in comparison to goods from other countries. This can result in increased exports, as consumers abroad are more willing to buy our goods than relatively more expensive goods. Furthermore, the lower income in the home country, automatically leads to reduced imports from abroad, as customers have less money to spend. Those two effects combined lead to an improvement of the country´s trade balance, as exports increase while at the same time imports decrease. While the depreciation of the currency has an overall positive impact on the trade balance and the exchange rate and is thus an argument in favour of fiscal austerity, this effect cannot always be counted on. It is obvious that if many countries try to implement fiscal austerity measures at the same time, the positive effects will be diminished, as not all countries can depreciate their currencies and improve their trade balance at the same time. That is exactly what we are seeing at the moment and this is why implementing fiscal austerity simultaneously in many countries affects economies more severely, as the positive effect on increased exports will not occur.

The aforementioned is however only true for countries with a flexible exchange rate regime. In countries with fixed exchange rates, the central bank has to intervene in order to keep the exchange rates fixed and maintain the same interest rate as before. Thereby the interest rate and the exchange rate will remain the same as before the decrease in government spending. The positive change in net exports is therefore smaller than in a country with flexible exchange rates, as the currency will not depreciate and therefore exports will not be increased. The only effect on the trade balance is the decrease in imports, as output and income in the home country decrease.

3.3 Output

GDP is probably the most evident indicator of current economic situation. The IS-LM model has already shown the dramatic change in GDP as result of cutting governmental expenditures.

In the case of GDP there are also differences in the results for countries with flexible and fixed exchange rate, and for countries with second type of exchange rate the consequences are even more harmful. As it was mentioned previously under the fixed exchange regime central banks have to decrease money supply in order to keep the domestic return on the same level. The shift of LM curve to the left decrease the output even more, what is tragic, the only positive result from the IS curve shift to the left – decrease in interest rate – is lost.

Domestic demand (consumption and investment) declines substantially in response to fiscal retrenchment. In particular, a consolidation of 1 percent of GDP reduces the contribution of domestic demand to GDP by about 1 percentage point after two years. This result is broadly consistent with “Keynesian” effects on demand of spending cuts and tax hikes.

It should be also mentioned, that in this case, that the fall in the value of the currency, which was explained previously, plays a key role in softening the impact of fiscal consolidation on output through the impact on net exports. Without this increase in net exports, the output cost of fiscal consolidation would be roughly twice as large, with output falling by 1 percent instead of 0.5 percent. Cuts in interest rates also help cushion the impact on consumption and investment.