5. Capital flight The following graph depicts the market for loanable funds measured in terms of the Mexican currency, the peso. ? The Market for Loanable Funds in Mexico Supply REAL INTEREST RATE (Percent) Demand LOANABLE FUNDS ( Billions of pesos ) Complete the first row of the table to reflect the state of the markets in Mexico. Assume the world interest rate is 6%. Real Interest Rate Net Capital Outflow (NCO) (Percent) (Billions of pesos) Initial state Risk premium after capital flight Now, suppose that Mexico experiences a sudden bout of political turmoil, which causes world financial markets to become uneasy. Because people now view Mexico as unstable, they decide to pull some of their assets out of Mexico and put them into more stable economies. This unexpected shock to the demand for assets in Mexico is known as capital flight. On the graph representing the market for loanable funds, shift the demand curve, the supply curve, or both to reflect the change caused by the political turmoil. Note: You will not be graded on your final placement of the curves on the graph, but you will need to shift them correctly in order to answer the questions that follow. Determine the risk premium after capital flight occurs, and enter it into the second row of the table. Then determine the level of NCO that occurs along the new NCO curve at the world interest rate with risk premium. Finally, show the effect of the change in NCO on the market for foreign exchange by shifting either the supply curve, the demand curve, or both. (?) The Market for Foreign-Currency Exchange Supply O Demand Supply REAL EXCHANGE RATE (Dollars per peso) Demand QUANTITY OF PESOS Summarize the results of capital flight by completing the following table. Real Exchange Rate Net Capital Outflow Effects of capital flight