Suppose the United States decides to reduce export subsidies on U. S. agricultural products, but it does not decrease taxes or increase any other government spending. Initially, a reduction in export subsidies decreases net exports at any given real exchange rate, causing the demand for dollars in the foreign exchange market to decrease. This leads to a decrease in the real exchange rate, which, in turn, decreases imports to negate any decrease in exports, leaving the equilibrium quantity of net exports and the trade deficit unchanged at this point.

1. However, the reduction in expenditure on export subsidies the fiscal deficit, thereby public saving.
2. Indicate the effect this has on the U. S. market for loanable funds. (Supply and demand shift?)
3. Given the change in the real interest rate, show the effect this has on net capital outflow.
4. This causes the supply of dollars in the foreign exchange market to , the real exchange rate to , and the equilibrium level of net exports to .

1. Decrease, increase

2. Supply curve shifts to the right

3. NCO will rise

4. Real exchange rate falls and net exports rises

Explanation:

Fiscal deficit occurs when government spending's exceed government revenue. When the government lowers its export subsidies while keeping other spending's and taxes unchanged, it leads to a fall in the fiscal deficit.

1. However, the reduction in expenditure on export subsidies decreases the fiscal deficit, thereby increases public savings.

2. As public savings increase it leads to an increase in funds available to be loaned out. So the supply curve for loanable funds will shift to the right from S1 to S2. This will lead to a fall in the interest rate.

3. As we know that net capital outflow is inversely related to the interest rate. A fall in the interest rate above will lead to a rise in net capital outflow.

4. When net capital outflow increases, people move funds out of the country. Thus, supply of dollars will increase. While demand for dollars has remained unchanged, it leads to a fall in the real exchange rate. As exchange rate falls, the equilibrium level of net exports will rise.

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