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 experiencinga trade deficit . Now, suppose the government is experiencing a budget deficit. This means thatnational saving will decrease , which leads toa decrease in the supply of loanable funds.
After the budget deficit occurs, suppose the new equilibrium real interest rate is 6%. 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
Initial Supply
Supply with Deficit
-20
-15
-10
-5
0
5
10
15
20
10
8
6
4
2
0
REAL EXCHANGE RATE
QUANTITY OF DOLLARS (Billions)
Demand
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