Answered: Consider a hypothetical open economy.…

Exploring Economics

8th Edition

ISBN:9781544336329

Author:Robert L. Sexton

Publisher:Robert L. Sexton

Chapter21: Financial Markets, Saving, And Investment

Section: Chapter Questions

Problem 6P

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Effects of a government budget deficit

Consider a hypothetical open economy. The following table presents data on the relationship between various real interest rates and national saving, domestic investment, and net capital outflow in this economy, where the currency is the U.S. dollar. Assume that the economy is currently experiencing a balanced government budget.

Real Interest Rate	National Saving	Domestic Investment	Net Capital Outflow
(Percent)	(Billions of dollars)	(Billions of dollars)	(Billions of dollars)
7	40	30	-20
6	35	35	-15
5	30	40	-10
4	25	45	-5
3	20	50	0
2	15	55	5

Given the information in the preceding table, use the blue points (circle symbol) to plot the demand for loanable funds. Next, use the orange points (square symbol) to plot the supply of loanable funds. Finally, use the black point (cross symbol) to indicate the equilibrium in this market.

Because of the relationship between net capital outflow and net exports, the level of net capital outflow at the equilibrium real interest rate implies that the economy is experiencing __________________ .

Now, suppose the government is experiencing a budget deficit. This means that __________ , which leads to ___________ loanable funds.

After the budget deficit occurs, suppose the new equilibrium real interest rate is 6%. The following graph shows the demand curve in the foreign-currency exchange market.

Use the green line (triangle symbol) to show the supply curve in this market before the budget deficit. Then use the purple line (diamond symbol) to show the supply curve after the budget deficit.

Given the information in the preceding table, use the blue points (circle symbol) to plot the demand for loanable funds. Next, use the orange points
(square symbol) to plot the supply of loanable funds. Finally, use the black point (cross symbol) to indicate the equilibrium in this market.
(?
Market for Loanable Funds
10
Demand
Supply
Equilibrium
20
40
60
80
100
QUANTITY OF LOANABLE FUNDS
REAL INTEREST RATE

On the following graph, plot the relationship between the real interest rate and net capital outfilow by using the green points (triangle symbol) to plot
the points from the initial data table. Then use the black point (X symbol) to indicate the level of net capital outflow at the equilibrium real interest
rate you derived in the previous graph.
Net Capital Outflow
10
NCO
6
Eqm. NCO
4
2
-20
-15
-10
-5
10
15
20
NET CAPITAL OUTFLOW (Billions of dollars)
REAL INTEREST RATE

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