Explain why government budget deficits crowd out private investment spending in a closed economy but crowd...

Explain why government budget deficits crowd out private investment spending in a closed

economy but crowd out net exports in a small open economy. Assume that prices are flexible

and that factors of production are fully employed in both economies. Assume that there is

perfect capital mobility for the small open economy.

Solutions

Expert Solution

In a closed economy, the budget deficit makes government to go for the deficit financing. It decreases the supply of savings in the loanable funds market. It causes interest rate to increase. Now, borrowing becomes expensive for the firms and they do not make investments. So, it is said that budget deficit is leading to crowding out the private investment.

For small open economy, budget deficit causes decrease in the national savings in the economy. It makes interest rate to increase and more capital comes into the country. At the same time, outflow of capital also decreases. It leads to the appreciation in the forex value of local currency and local currency appreciates. It leads to decrease in net exports. So, it is said that budget deficit causes, crowding out net exports in small open economy.

Rahul Sunny answered 1 year ago

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