Question

3. 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. 

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.

On the following graph, plot the relationship between the real interest rate and net capital outflow 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.

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. 

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 7%. The following graph shows the demand curve in the foreign-currency exchange market.

Summarize the effects of a budget deficit by filling in the following table. 

Answer 1

National saving is supply of loanable funds & domestic investment is demand for loanable funds.

Their interesection is equilibrium.

Market for Loanable Funds 10 Demand supply Supply eqm demand Equilibrium 20 40 60 80 100 QUANTITY OF LOANABLE FUNDS

At equilibrium, interest rate is 5% & funds = 40 billion $.

NCO

Net Capital Outflow 10 NCO Eqm. NCO 10 520 -20 15 10-5 0 5 NET CAPITAL OUTFLOW (Billions of dollars)

Eqm real interest rate = 5%

Since NCO is zero at equilibrium, then balanced trade exists.

If budget deficit , then national saving will decrease, which leads to fall in supply of loanable funds, .

Hence supply curve will shift upwards towards left.

New eqm interest rate = 7%

Now forex market:

Market for Foreign-Currency Exchange 10 Initial Supply Supply with Deficit Demand -2015 10 -5 0 5 10 15 20 QUANTITY OF DOLLARS (Billions)

At eqm, quantity of dollars equals the NCO at eqm.

Now before deficit, eqm NCO, is 0, so supply is vertical line at Q= 0

Now after deficit, r = 7%, so new NCO = -10, so at Q=-10, draw a vertical line , that cuts demand curve at exchange rate = 5

Thus real exchange rate rise from 3 to 5.

Effects of budget deficit:

real interest rate : will increase

real exchange rate : increases

trade balance : deficit

Answer 2

Answer Above is corret just make sure you plot each point on the chart