Question

Assume the South African’s government budget deficit decreases. Use the loanable funds, NFI and foreign exchange market diagrams combined as in the previous slides to explain the impact of this on the South African interest rates and exchange rates

Answer 1

As government budget deficit is decreasing, it causes positive public saving, it increases national saving. This leads to an increase in the supply of loanable funds.

The real interest rate reduces, leading to an increase in both domestic investment and net foreign investment (NFI).

Because net foreign investment increases, the supply of dollars increases.

The real exchange rate reduces, exports will rise, imports will reduce, and net exports will rise.

Thus, in an open economy, decrease in government budget deficits decrease real interest rates, domestic investment increases, cause the dollar to depreciate, and push the trade balance toward surplus.