Question

D 7 Which of the followings are effects of the budget deficit Select all that apply Net exports increase The real exchange rate appreciates The real interest rate rises National saving falls 8 Suppose coffee sells for $3/pound in Seattle and $5/pound in Boston, and the transportation between the two cities costs $3/pound. Then there is no arbitrage. True False

Answer 1

7. Options: 2 and 3

Budget deficit would mean increase in government spending and reduction in taxes. This would shift the aggregate demand curve to the right. This would also shift the IS curve to the right raising both output and real interest rate. Now rise in real interest rate would cause an inflow of foreign capital. This shifts the supply of foreign capital to the right and the price of unit foreign capital in domestic currency falls. This means real exchange rate appreciates as domestic currency per unit foreign currency falls and value of domestic currency increases.

8. True

Without transportation cost between the two cities there was an arbitrage opportunity: buying coffee in Seattle and selling it in Boston would have earned a profit of $2. But with transportation cost $3 which is greater than the potential profit, arbitrage wiped out.