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.

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. 

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.

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. 

Answer 1

National saving is supply of loanable funds

Domestic investment is demand for loanable funds

Eqm is found at the intersection of two curves.

Graph of NCO

Economy is experiencing balanced budget

Now budget deficit national saving will decrease

Which leads to fall in supply of loanable funds

New eqm rate - 7%

Initial supply is vertical line at 0 dollar ,. Bcoz NCO at .Eqm is Quantity of dollars , initially NCO is zero.

After trade deficit, new NCO at r = 7%, = -10

so new supply curve is vertical line at Q= -10

Original exchange rate = 3%

New exchange rate ,= 5% , ( as demand & supply cuts at 5%)

Graph

	Real interest rate	real exchange rate	trade balance
Effect of budget Deficit	increase	increase	deficit