Question

Question 7. Use diagrams for the market for loanable funds and the market for foreign currency to describe what would happen to Net Capital Outflow, the Canadian Real Exchange Rate and Net Exports if the government budget deficit increases.

Answer 1

An increase in the budget deficit of the government would result in raising the rate of interest when it shifts the supply curve for loanable funds to the left. This is likely to reduce the net capital outflow as foreign investment will start pouring in. As demand for local currency rises, its price would rise and this causes the currency to appreciate.

For Canadian economy, this implies a decline in net capital outflow as well as net exports and an increase in the value of Canadian Real Exchange Rate showing an appreciation.