Question

ECON 2305

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.

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.

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 (balanced trade, a trade surplus).

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 the demand for, a decrease in the demand for)  loanable funds.

After the budget deficit occurs, suppose the new equilibrium real interest rate is 6%. 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.

Summarize the effects of a budget deficit by filling in the following table.

Real Interest Rate (Increase or Decrease)

Real Exchange Rate (Increase or Decrease)

Trade Balance (Surplus or Deficit)

Answer 1