Question

From 2001 to 2004, the U.S. government went from a budget surplus to a budget deficit. According to the open-economy macroeconomic model, this should have decreased a. the supply of loanable funds but not the supply of dollars in the market for foreign-currency exchange. b. both the supply of loanable funds and the supply of dollars in the market for foreign-currency exchange. c. neither the supply of loanable funds nor the supply of dollars in the market for foreign-currency exchange. d. the supply of dollars in the market for foreign-currency exchange, but not the supply of loanable funds.

Answer 1

Answer: Option (a) is correct.

Explanation:

Correct Option: The supply of loanable funds but not the supply of dollars in the market for foreign-currency exchange.

If the budget deficit increases, then U.S residents will want to purchase fewer foreign assets and foreign residents wants to buy more of U.S assets.

The budget deficit in the economy has to be financed either by borrowing or by increasing taxes. This budget deficit occurred because of the tax cuts and higher government spending.

If a country running a budget deficit, which lead to reduction in national saving. We all know that interest rate is determined in the loan market, where savers supply the loans to the private borrowers.

So, if there is a fall in the national saving, this will reduced the supply of loans from savers, which raises the interest rate in an economy.

This will attract the foreign flow of capital. This means that demand for domestic assets increases because of the higher interest rate.

Now, if foreign residents want to take an advantage of higher interest rate then they first have to acquire domestic currency.

Therefore, higher interest increases the demand for domestic currency in a market of foreign exchange.