Question

The graphs below depict the loanable funds market and the relationship between real interest rates and the level of net capital outflow (NCO) calculated in terms of the Mexican peso. Complete the first row of the table to reflect the state of the markets in Mexico. Suppose now that a sudden bout of political turmoil in Mexico causes world financial markets to become uneasy. Because investors now see Mexico as unstable, they decide to pull a portion of their assets out of Mexico and put them into more stable economies. This unexpected shock to the demand for assets in Mexico is known as capital flight. Shift the NCO curve to illustrate the effect of capital flight. Then, on the graph representing the market for loanable funds, shift the supply curve, the demand curve, or both curves to reflect the change caused by the shift in NCO. Note: You will not be graded on your final placement of the curves on the graph, but you will need to shift them correctly in order to answer the questions that follow. Determine the equilibrium interest rate after capital flight occurs, and enter it into the second row of the table. Then determine the level of NCO that occurs along the new

NCO

curve at the new equilibrium interest rate. Finally, show the effect of the change in NCO on the market for foreign exchange by shifting either the supply curve, the demand curve, or both. Summarize the results of capital flight by completing the following table.

Answer 1

Based on the provided graphs and instructions, the task is to determine the real interest rate and net capital outflow before and after capital flight in Mexico, as well as the effects on the foreign exchange market.

Initially, the equilibrium real interest rate is approximately 4%, and the corresponding net capital outflow (NCO) is roughly -1 billion pesos. After capital flight, we would expect the real interest rate to increase and the NCO to become more negative (greater outflow).

1. Initial State:

- From the "Market for Loanable Funds in Mexico" graph, the intersection of the supply and demand curves (equilibrium) is at a real interest rate of approximately 4%.

- At this interest rate, the loanable funds available are about 3 billion pesos.

- Moving to the "Mexican Net Capital Outflow" graph, an amount of 3 billion pesos of loanable funds corresponds to an NCO of approximately -1 billion pesos.

2. After Capital Flight:

- Political turmoil and capital flight would shift the demand curve for loanable funds to the left, indicating a decrease in demand.

- This would result in a new equilibrium with a higher real interest rate and lower quantity of loanable funds available.

- The higher real interest rate would, in turn, increase the NCO, as more investors seek to invest abroad rather than in the now less stable Mexican economy.

3. Effects on Foreign Exchange Market:

- An increase in NCO means more pesos are being exchanged for foreign currency, shifting the supply curve of pesos in the foreign exchange market to the right.

- This would result in a depreciation of the peso (higher real exchange rate) and an increase in the quantity of pesos exchanged.

4. Completing the Tables:

- The initial real interest rate is entered as 4%, and the initial NCO as -1 billion pesos.

- After capital flight, these values will be adjusted based on the shifts in the curves, with an expected increase in the real interest rate and a more negative NCO.

- The real exchange rate would rise, indicating a depreciation of the peso due to the increased supply of pesos in the foreign exchange market.

To provide precise post-capital flight values, one would typically estimate the new equilibrium points based on the graphs' shifted curves. Since the shifts are not provided in numerical form, we can only indicate the expected direction of the changes.

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