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5. Capital flight The following graphs depict the market for...

5. Capital flight

The following graphs depict the market for loanable funds and the relationship between the real interest rate and the level of net capital outflow (NCO) measured in terms of the Mexican currency, the peso.

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 flight

Now, suppose that Mexico experiences a sudden bout of political turmoil, which causes world financial markets to become uneasy. Because people now view Mexico as unstable, they decide to pull some 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 demand curve, the supply curve, or both 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.

Summarize the results of capital flight by completing the following table.

Real Interest Rate Real Exchange Rate Net Capital Outflow

Effects of capital flight (increase, decrease) (increase, decrease) (decrease, increase)

Answer & Explanation
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