Question 3

3. Effects of a government budget deficit Suppose a hypothetical open economy uses the LS. dollar as currency. The table below presents data describing the relationship between different real interest rates and this economy's levels of national saving, domestic investment, and net capital outflow. Assume that the economy is currently operating under a balanced government budget. Real Interest Rate National Saving (Percent) (Billions of dollars) 7 2w 50 45 40 35 20 25 Domestic Investment (Billions of dollars) 30 40 S0 &0 70 80 Net Capital Outflow (Billions of dollars) =20 -15 -10 -5 o Given the information in the table above, use the biue points (circle symbol) to plat the demand for laanable funds. Next, use the orange points (square symbal) to plot the supply of loanabie funds. Finally, use the black point (cross symbol) to indicate the equilibrium in this market. REALINTERESTRATE Market for Loanable Funds () Q) Demand Supply + Equilibrium =l t t 20 40 &0 B QUANTITY OF LOANABLE FUNDS 100 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. pital Outflow 10 A NCO .+ Eqm. NCO REAL INTEREST RATE -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 Now, suppose the government is experiencing a budget deficit. This means that , which leads to loanable funds. After the budget deficit occurs, suppose the new equilibrium real interest rate is 7%. 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. Market for Foreign-Currency Exchange 10 A Initial Supply O Supply with Deficit REAL EXCHANGE RATE Demand -20 -15 -10 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 Deficit Grade It Now Save & Continue