Question

In order to stop the capital flight and avoid further depreciation of rupiah, one of the President Candidate suggests that government should start increasing the government budget surplus. Evaluate the suggestion using relevant diagrams.

Answer 1

Increasing budget surplus will further deteriorate the problems.

When budget surplus increases, public savings increases, which will increase national savings. The savings curve shifts rightward, decreasing interest rate and increasing equilibrium saving and investment.

As interest rate decreases, net capital outflow (i.e. capita flight) increases, which increases net exports. Since net exports and exchange rate are inversely related, higher net exports decreases exchange rate.

In following graph, panel A shows national saving (S) and investment (I) curves. S0 and I0 are initial national saving and investment curves intersecting at point A with initial interest rate r0 and initial savings & investment Q0.

When national savings increase, S0 shifts right to S1, intersecting I0 at point B with lower interest rate r1 and higher quantity of saving and investment Q1.

In panel B (depicting net capital outflow as an inverse function of interest rate), lower interest rate from r0 to r1 increases net capital outflow (capital flight) from NCO0 to NC01.

In panel C (depicting net exports as an inverse function of exchange rate), an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and decreases exchange rate from e0 to e1. So the currency depreciates.