An economy is at equilibrium. Use the model of a loadable funds Market to determine the...

An economy is at equilibrium. Use the model of a loadable funds Market to determine the net effect on real interest rates and real exchange rates from a decrease in government expenditures

Expert Solution

Consider the market for loanable fund where “E1” be the initial equilibrium where “i1” be the equilibrium interest rate and “e1” be the equilibrium real exchange rate.

Now, as the government decreases its spending, => the “supply of loanable fund” increases, => the supply curve will shift to the right side to “S2”, => the new equilibrium is “E2”, => the equilibrium interest rate decreases to “i2 < i1”. Now, as the interest rate decreases, => the NCO increases as there is a negative relationship between them.

Now, as the NCO increases, => the supply of foreign exchange reserve increases, => the supply of foreign exchange increases to “SFX2”. So, the given the “foreign exchange demand” the as the supply decreases, => the equilibrium “real exchange rate” also decreases to “e2” from “e1". So, as the “government spending” decreases, => the equilibrium “real interest rate” as well as the “real exchange rate” both decreases.

Rahul Sunny answered 2 years ago

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