Question

ECO - 252 - Macroeconomics

5. Use the open-economy macroeconomics model to explain what happens if the Turkish government budget deficit increases. Be thorough and work through the model from Turkey’s perspective.

Answer 1

When the budget deficit of the government increases the government will attempt to finance it by borrowing. This borrowing will take place from the loanable funds market and therefore the demand curve for loanable funds will shift to the right. There will be an increase in the interest rates on Turkish deposits. Higher interest rate on Turkish deposits relative to world interest rate will attract foreign capital. This will reduce net capital outflow and there will be an increase in the demand for Turkish currency. When the demand for Turkish currency increases the price of Turkish currency will increase which means it will appreciate against other currencies. This appreciation is expected to increase imports and reduce exports so that that exports will fall. Therefore an increase in the government budget deficit is likely to bring foreign capital which will reduce net exports.