5. Capital flight

The graphs below depict the loanable funds market and the relationship between real interest rates and the level of net capital outflow (NCO) calculated in terms of the Mexican peso.

The Market for Loanable Funds in MexicoDemandSupply012345678987654321REAL INTEREST RATE (Percent)LOANABLE FUNDS (Billions of pesos)DemandSupply

Mexican Net Capital OutflowNCO-4-3-2-10123456987654321REAL INTEREST RATE (Percent)NET CAPITAL OUTFLOW (Billions of pesos)NCO

Complete the first row of the table to reflect the state of the markets in Mexico.

	Real Interest Rate	Net Capital Outflow (NCO)
(Percent)	(Billions of pesos)
Initial state
After capital flight

Suppose now that a sudden bout of political turmoil in Mexico causes world financial markets to become uneasy. Because investors now see Mexico as unstable, they decide to pull a portion 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.

Shift the NCO curve to illustrate the effect of capital flight. Then, on the graph representing the market for loanable funds, shift the supply curve, the demand curve, or both curves to reflect the change caused by the shift in NCO.

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 equilibrium interest rate aftercapital flight occurs, and enter it into the second row of the table. Then determine the level of NCO that occurs along the newNCO curve at the newequilibrium interest rate.

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 ExchangeDemandSupplyREAL EXCHANGE RATE (Dollars per peso)QUANTITY OF PESOSDemandSupply

Summarize the results of capital flight by completing the following table.

	Real Interest Rate	Real Exchange Rate	Net Capital Outflow
Effects of capital flight