Question 5

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 Mexico Mexican Net Capital Outflow Supply ch ch REAL IN TEREST RATE (Percent) REAL IN TEREST RATE (Percent) NCO Demand N 0 2 4 3 2-1 0 1 2 3 5 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 After capital flightSuppose 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 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 Demand Supply REAL EXCHANGE RATE ( Dollars per peso) Demand QUANTITY OF PESOSSummarize the results of capital flight by completing the following table. Real Interest Rate Real Exchange Rate Net Capital Outflow Effects of capital flight - - 0w - T e