Question

The increase of budget deficit, decreases the supply of loanable funds and the supply curve shifts left. Discuss the possible effects of this crowding out effect in an open economy.

Answer 1

An increase of budget deficit means the revenue is less than the expenditure. So the availability of loanable funds decreases shifting the supply curve to the left. There will be a decrease in quantity along with an increase in the interest rate.

Now when the interest rate increases it will be having an impact on the net capital outflows of the economy. The net capital outflows will decrease and this inturn will affect the exchange rate. The currency of the country will face an appreciation as a result of the process.

The appreciation of currency will lead to an increase in the import of goods and services. On the other hand exports are negatively affected.