Principles of Economics- Mankiw (5th) 667

Principles of Economics- Mankiw (5th) 667 - causes the real...

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CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 689 An important example of this lesson occurred in the United States in the 1980s. Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of the U.S. federal government changed dramatically. The president and Congress enacted large cuts in taxes, but they did not cut government spending by nearly as (a) The Market for Loanable Funds (b) Net Foreign Investment Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Foreign Investment Real Exchange Rate r 1 1 E 1 2 Demand Demand 2 2 NFI S 1 2 2 1 B A 1. A budget deficit reduces the supply of loanable funds . . . 2. . . . which increases the real interest rate . . . 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency . . . 5. . . . which
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Unformatted text preview: causes the real exchange rate to appreciate. 3. . . . which in turn reduces net foreign investment. Figure 30-5 T HE E FFECTS OF A G OVERNMENT B UDGET D EFICIT . When the government runs a budget deficit, it reduces the supply of loanable funds from S 1 to S 2 in panel (a). The interest rate rises from r 1 to r 2 to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net foreign investment. Reduced net foreign investment, in turn, reduces the supply of dollars in the market for foreign-currency exchange from S 1 to S 2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate from E 1 to E 2 . The appreciation of the exchange rate pushes the trade balance toward deficit....
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This note was uploaded on 07/30/2010 for the course ECON 120 taught by Professor Abijian during the Spring '10 term at Mesa CC.

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