【正文】 ng, domestic investment, net foreign investment, and net exports.III. How Policies and Events Affect an Open EconomyFor the next three applications, use the threestep process developed in Chapter 4. First, determine which of the supply and demand curves have been affected. Second, determine in which direction the curves shift, and finally, use the supply and demand diagrams to examine how these shifts alter equilibrium in the two markets. A. Government Budget DeficitsFigure 3051. A government budget deficit occurs when the government spending exceeds government revenue.rS2rS1r*2r*1NFID (I+NFI)Q of loanable fundsNFIreal eS1S2real e*2real e*1D (NX)Q of dollars2. Because a government deficit represents negative public saving, it lowers national saving. This leads to a decline in the supply of loanable funds.3. The real interest rate rises, leading to a decline in both domestic investment and net foreign investment.4. Because net foreign investment falls, people need less foreign currency to buy foreign assets so the supply of dollars declines.5. The real exchange rate rises, making . goods more expensive relative to foreign goods. Exports will fall, imports will rise, and net exports will fall.6. In an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade balance toward deficit. 7. Because they are so closely related, the budget deficit and the trade deficit are often called the twin deficits. Note that, because many other factors affect the trade deficit, these “twins” are not identical.Now would be a good time to discuss the debate in Chapter 34 concerning whether the federal government should reduce the government debt.B. Trade PolicyFigure 3061. Definition of Trade Policy: a government policy that directly influences the quantity of goods and services that a country imports or exports.2. Two mon types of trade policies are tariffs (taxes on imported goods) and quotas (limits on the quantity of imported goods).3. Example: the . government imposes a quota on the number of cars imported from Japan.4. Note that the quota will have no effect on the market for loanable funds. Thus, the real interest rate will be unaffected. 5. The quota will lower imports and thus increase net exports. Since net exports are the source of demand for dollars in the market for foreigncurrency exchange, the demand for dollars will increase.6. The real exchange rate will rise making . goods relatively more expensive than foreign goods. Exports will fall, imports will rise, and net exports will fall.7. In the end, the quota reduces both imports and exports but net exports remain the same.rrS (saving)r*NFID (I+NFI)Q of loanable fundsNFIreal eS(NFI)real e*2real e*1D2D1Q of dollars8. Thus, trade policies do not affect the trade balance.9. Recall that NX = NFI. Also remember that S = I + NFI.Rewriting, we get: NFI = S – I.Substituting for NFI, we get:NX = S – I.10. Since trade policies do not affect national saving or domestic investment, they cannot affect net exports.11. Trade policies do have effects on firms, industries, and countries. But these effects are more microeconomic than macroeconomic.C. Political Instability and Capital Flight1. Definition of Capital Flight: a large and sudden reduction in the demand for assets located in a country.2. Capital flight often occurs because investors feel that the country is unstable, due to either economic or political problems.3. Example: Investors around the world observe political problems in Mexico and begin selling Mexican assets and buying . assets.Figure 3074. Mexican net foreign investment will rise because investors are selling Mexican assets and purchasing assets from another country.a. Since net foreign investment determines the supply of pesos, the supply of pesos increases.b. Since net foreign investment is also a part of the demand for loanable funds, the demand for loanable funds rises.5. The increased demand for loanable funds causes the equilibrium real interest rate to rise.6. The increased supply of pesos lowers the equilibrium real exchange rate.7. Thus, capital flight from Mexico increases Mexican interest rates and lowers the value of the Mexican peso in the market for foreigncurrency exchange.rrS (saving)r*2r*1NFI2D2NFI1D1Q of loanable fundsNFIreal eS1S2real e*1real e*2D (NX)Q of pesos 8. Capital flight in Mexico will also affect other countries. If the capital flows out of Mexico and into the United States, it has the opposite effect on the . economy. 9. In 1997, several Asian countries experienced capital flight. The same thing occurred in Russia in 1998. D. In the News: How the Chinese Help American Home Buyers 1. China is using funds from its large trade surpluses to purchase . securities. 2. This is an article from The Wall Street Journal covering the effects of this influx of capital on . interest rates.ALTERNATIVE CLASSROOM EXAMPLE:Suppose that investors feel very confident about the prospects for investment in Brazilian assets.In this case (from the perspective of Brazil):1. The demand for loanable funds will shift left because NFI decreases. 2. The NFI curve will also shift left.3. The real interest rate in Brazil will fall.4. The supply of Reals (the “Re