Chartered Financial Analyst (CFA) Practice Exam Level 2

What effect does expansionary fiscal policy typically have on a country's currency?

1. Appreciation due to increased foreign investment

2. Stability in currency values

3. Depreciation as debt levels rise

4. No effect on the currency

The correct answer is: Depreciation as debt levels rise

Expansionary fiscal policy generally involves increased government spending and/or tax cuts aimed at stimulating the economy. When a government engages in such policies, it often leads to higher budget deficits, as expenditures outpace revenues. As a result, the national debt tends to rise. This increase in debt can create concerns among investors regarding the country's fiscal health. Higher debt levels can lead to perceptions of increased risk, potentially causing a depreciation of the currency. Investors may seek safer assets or shift their investments to other countries with more stable economic policies, which could further weaken the currency. In contrast, the other options suggest effects that do not align as closely with the principles of economic theory. While foreign investment could theoretically increase with government spending, especially in growth sectors, the immediate impact of rising debt on currency strength usually leans towards depreciation rather than appreciation. Stability in currency values typically occurs in scenarios of low debt or robust economic signals, while expansionary fiscal policy can introduce volatility. Lastly, considering that fiscal policy often influences economic expectations, it usually does have some effect on currency, making the notion that it has no effect unlikely. Thus, the connection between rising debt levels and currency depreciation is supported by the economic rationale surrounding investor behavior and risk perception.