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.

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: (balanced trade / a trade surplus / a trade deficit).

Now, suppose the government is experiencing a budget deficit. This means that: (national saving will increase / national saving will decrease / domestic investment will increase / domestic investment will decrease), which leads to: (an increase in the supply of / a decrease in the supply of / an increase in demand for / a decrease in the demand for)loanable funds.

Answer 1

The supply of loanable funds is the national savings of the economy and the demand for loanable funds is the investment plus the net capital outflow. the equilibrium occurs where S=I+NCO.

The table for demand and supply of funds is given below

Real Interest rate	National Saving	Domestic Investment	NCO	I+NCO
7	55	25	-15	10
6	50	30	-10	20
5	45	35	-5	30
4	40	40	0	40
3	35	45	5	50
2	30	50	10	60

The table is depicted below:

The equilibrium real interest rate is 4 in the economy.

The net capital outflow (NCO) the second last column in depicted below

In the economy, the net capital outflow is equal to the net export. That is at equilibrium, NX=NCO. At the real interest of 4, NCO=0, then NX=0.

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: (balanced trade).

The national savings is the sum of public savings and private savings. Public savings is equal to government budget surplus (T-G).

Now, suppose the government is experiencing a budget deficit. This means that: (national saving will decrease), which leads to: (a decrease in the supply of) loanable funds.

Let the new equilibrium interest rate becomes 6, at this level NX=NCO=-10. At this level of net export, the real exchange rate is 5. The initial exchange rate was 3.

Summarization of the effects of an increase in the budget deficit:

• Real Interest Rate: Increases

• Real Exchange Rate: Increases

• Trade Balance: Deficit