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1. Introduction to the loanable funds market In a large open economy, what is the source of the domestic supply of loanable funds? 0 National saving 0 Net foreign investment 0 Investment O National saving and investment 2. Introduction to the foreign-currency exchange market In an open economy, what is the source of demand for dollars in the foreigncurrency exchange market? 0 Net exports 0 Imports 0 Net capital outflow O National saving 3. 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 US. dollar. Assume that the economy is currently experiencing a balanced government budget. Real Interest Rate National Saving Domestic Investment Net Capital Outflow (Percent) (Billions of dollars) (Billions of dollars) (Billions of dollars) 7 65 1 5 1 0 6 60 2 5 5 5 5 5 3 5 0 4 50 45 5 3 45 5 5 1 O 2 40 65 1 5 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. Market for Loanable Funds 10 O Demand 8 6 Supply REAL INTEREST RATE Equilibrium 2 0 20 40 60 80 100 QUANTITY OF LOANABLE FUNDSOn 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. Net Capital Outflow 10 NCO Eqm. NCO REAL INTEREST RATE 4 2 O- -20 -15 -10 -5 0 5 10 15 20 NET CAPITAL OUTFLOW (Billions of dollars)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 V . Now, suppose the government is experiencing a budget deficit. This means that V , which leads to V loanable funds. After the budget decit occurs, suppose the new equilibrium real interest rate is 5%. The following graph shows the demand curve in the foreign- currency exchange market. 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 v . balanced trade Now, suppose the government is get deficit. This means that V , which leads to a trade deficit d5- a trade surplus After the budget decit occurs, 5 ilibrium real interest rate is 5%. The following graph shows the demand curve in the foreign- currency exchange market. 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 v . Now, suppose the government is experiencing a budget deficit. This means that v , which leads to V loanable funds. national saving will increase After the budget decit occurs, suppose the new equilibrium real interest rate is national saving will decrease emand curve in the foreign- currency exchange market. domestic investment will increase domestic investment will decrease Use the green line (triangle symbol) to show the supply curve in this market be' urple line (diamond symbol) to 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 V . Now, suppose the government is experiencing a budget deficit. This means that V , which leads to V loanable funds. an increase in the supply of ppose the new equilibrium real interest rate is 5%. The following graph shows the demand curve in the foreign- a decrease in the supply of an increase in the demand for I) to show the supply curve in this market before the budget decit. Then use the purple line (diamond symbol) to a decrease in the demand for udget deficit. 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. Market for Foreign-Currency Exchange 10 A Initial Supply 8 6 Supply with Deficit REAL EXCHANGE RATE 4 2 Demand -20 -15 -10 -5 0 5 10 15 20 QUANTITY OF DOLLARS (Billions)Summarize the effects of a budget deficit by filling in the following table. Real Interest Rate Real Exchange Rate Trade Balance Effects of a Budget DeficitDecreases Summarize the effects of a budget 1 g in the following table. R Rate Real Exchange Rate Trade Balance Effects of a Budget Deficit V Y Y Increases Summarize the effects of a budget deficit by filling in the foll Decreases Real Interest Rate Re Rate Trade Balance Effects of a Budget DeficitSurplus Summarize the effects of a budget deficit by filling in the following table. Deficit Real Interest Rate Real Exchange Rate ince Effects of a Budget Deficit4. Analyzing the effects of a trade deficit You have just been hired by the U.S. government to analyze the following scenario. Suppose the U.S. manufacturing industry is concerned about competition from overseas lowcost producers exporting their goods to the United States, a practice that hurts domestic producers. Lobbyists claim that implementing a tariff on imports would shrink the size of the trade decit. The following exercise will help you to analyze this claim. The following graph shows the demand and supply of U.S. dollars in a model of the foreign-currency exchange market. Shift the demand curve, the supply curve, or both to show what would happen if the government decided to implement the tariff. Supply Demand Supply Demand REAL EXCHANGE RATE (Units of foreign currency per dollar) QUANTITY OF DOLLARS Given this change, the dollar V . Fill in the following table with the effect of a tariff on the following items: Supply of Loanable Funds Real Interest Rate Net Capital Outflow Net Exports Change due to a tariff V V V V Given this change, the dollar V . depreciates Fill in the following table with tariff on the following items: Supply of Loanable Funds Real Interest Rate Net Capital Outflow Net Exports Change due to a tariff V V V V Given this change, the dollar V . Increase Fill in the following table with the e fon the following items: Decrease No change Supp e Funds Real Interest Rate Net Capital Outflow Net Exports Change due to a tariff V V V V Given this change, the dollar V . Fill in the following table with the effect of a tariff on the follo Increase Decrease No change Supply of Loanable Funds R Rate Net Capital Outflow Net Exports Change due to a tariff V V V V Given this change, the dollar Fill in the following table with the effect of a tariff on the following items: Increase Decrease No change Supply of Loanable Funds Real Interest Rate N tflow Net Exports Change due to a tariff V V V V 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 Mexican Net Capital Outow 5 \" Supply 5 NCO REAL INTEREST RATE (Percent) (40 I I I I I I + REAL INTEREST RATE (Percent) (A . 1 O 1 2 3 4 5 6 7 8 4 3 2 1 1 2 3 4 5 6 LOANABLE FUNDS (Billions of pesos) NET CAPITAL OUTFLOW (Billions of pesos) 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 C |:' l: |:i 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. 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 reect 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 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 new equilibrium 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 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 Interest Rate Real Exchange Rate Net Capital Outflow Effects of capital flightFinally, 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 Decrease Summarize the results of capital mpleting the following table. Increase Re Rate Real Exchange Rate Net Capital Outflow Effects of capital flightFinally, 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 Increase Summarize the results of capital flight by completing the ble. Decrease Real Interest Rate Re: e Rate Net Capital Outflow Effects of capital flightFinally, 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 Decrease Summarize the results of capital flight by completing the following table. Increase Real Interest Rate Real Exchange Rate Ne Itflow Effects of capital flight