ELS Chapter 15: Graphing Exercise Answers
International Capital Flows
1. What is the effect of an increase in the federal government's budget deficit on domestic real interest rates, the capital inflow, and the trade deficit? What do you conclude about the relationship between a country's level of national saving and its trade deficit?
  answer: A reduction in national saving shifts the S+KI curve to the left, creating an excess demand for saving at the original real interest rate. Borrowers "bid up" the real interest rate in response to the excess demand. As the real interest rate rises, the level of domestic saving increases some (along the S+KI curve) and the level of investment falls some (along the I curve). At the new equilibrium the real interest rate is higher and the level of investment is lower than at the original equilibrium. The higher domestic real interest rates induce foreigners to buy domestic assets, increasing capital inflows (see the section on "The Determinants of International Capital Flows" in the text). The higher domestic real interest rates also discourage domestic savers from buying foreign assets, reducing the capital outflow. Net capital inflows increase. Since the net capital inflow is the same as the trade deficit (or -NX), as the net capital inflow increases, so does the trade deficit. Conclusion: a reduction in national saving increases a country's trade deficit.
2. During the 1990s the U.S. federal budget deficit shrank, eventually turning into a budget surplus by the late 1990s. Yet, during this time the trade deficit continued to grow. According to the model, what else must have been occurring that led to the increased trade deficits?
  answer: A reduction in the federal budget deficit will increase public and national saving, shifting the S+KI curve to the right, reducing the domestic real interest rate, increasing the level of investment, and reducing the capital flow and the trade deficit. However, trade deficits continued to grow during the 1990s, not fall as the model suggests. Therefore, there must have been other factors at work in addition to the reduction in the federal budget deficit. Indeed, during the mid-to-late 1990s, technology was increasing the productivity of capital, leading to an increase in investment and shifting the I curve to the right. The increase in I helped to keep real interest rates high and provided an incentive for foreigners to acquire U.S. assets, thus increasing the capital inflow and the trade deficit at the same time that the federal budget deficit was decreasing. In this case movements in the budget and trade deficits were not directly related; indeed, they moved in opposite directions.
3. What are the economic effects of an increase in the perceived risk of owning a country's assets?
  answer: An increase in the riskiness of a country's assets reduces that country's net capital inflows, as foreigners become less willing to buy that country's assets and domestic savers become more inclined to buy foreign assets. The S+KI curve shifts to the left, raising the country's domestic interest rate and reducing domestic investment in new capital, reducing economic growth.

4.

 What are the economic effects of an increase in technology that improves the productivity of capital in a country?
  answer: An increase in technology that improves the productivity of capital increases the expected return to firms' investment, increasing the level of investment at each interest rate and shifting the I curve to the right. The equilibrium domestic interest rate increases, along with the level of investment, and the capital inflow into the country increases as well in response to the increased interest rate. As a result, the country's trade deficit increases.