Back to Assignment

Attempts:Keep the Highest:no score out of 3

/3

5. Capital flight

The following graphs depict the market for loanable funds and the relationship between the real interest rate and the level of net capital outflow (NCO) measured in terms of the Mexican currency, the peso.

The Market for Loanable Funds in Mexico

Demand

Supply

0

1

2

3

4

5

6

7

8

9

8

7

6

5

4

3

2

1

REAL INTEREST RATE (Percent)

LOANABLE FUNDS (Billions of pesos)

Demand

Supply

Mexican Net Capital Outflow

NCO

-4

-3

-2

-1

0

1

2

3

4

5

6

9

8

7

6

5

4

3

2

1

REAL 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 RateNet Capital Outflow (NCO)(Percent)(Billions of pesos)Initial stateAfter 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 ascapital flight.

Shift the NCO curve to illustrate the effect of capital flight. Then, 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 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 rateaftercapital flight occurs, and enter it into the second row of the table. Then determine the level of NCO that occurs along thenewNCO curve at thenewequilibrium 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 Exchange

Demand

Supply

REAL EXCHANGE RATE (Dollars per peso)

QUANTITY OF PESOS

Demand

Supply

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

Real Interest RateReal Exchange RateNet Capital OutflowEffects of capital flight