Question 5 Chapter 19 Capital flight
Explanation: Close Explanation
The equilibrium interest rate is determined by the intersection of the supply and
... [Show More] demand curves in the market for loanable
funds. This occurs at an interest rate of 5%. The level of net capital outflow corresponding to this interest rate can be read
off the NCO curve and is equal to $1 billion.
5. Capital flight
The following graphs depict the market for loanable funds and the relationship between the real interest rate and the level of net
capital outflow (NCO) measured in terms of the Mexican currency, the peso.
Complete the first row of the table to reflect the state of the markets in Mexico.
Real Interest Rate Net Capital Outflow (NCO)
(Percent)
Initial state
After capital flight
5
6
Points: 0.5 / 1
Now, suppose that Mexico experiences a sudden bout of political turmoil, which causes world financial markets to become uneasy.
Because people now view Mexico as unstable, they decide to pull some 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. REAL INTEREST RATE (Percent) REAL INTEREST RATE (Percent)
Your Answer
Explanation: Close Explanation
If people decide to move their capital to safer havens, net capital outflow in Mexico increases for any given real interest rate.
This results in a rightward shift of the NCO curve.
The demand for loanable funds is composed of net capital outflow and domestic investments, which causes the demand for
loanable funds to increase in Mexico, and in turn causes the real interest rate to rise. After the shift, the equilibrium interest
rate is equal to 6%. Referring back to the graph on the right, this new rate corresponds to a new NCO level of $1.5 billion.
Shift the NCO curve to illustrate the effect of capital flight. Then, on the graph representing the market for loanable funds, shift the
demand curve, the supply curve, or both 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.
Points: 0 / 1
Correct Answer
The Market for Foreign-Currency Exchange
S1 S2
Demand
Supply
Demand
QUANTITY OF PESOS
REAL EXCHANGE RATE (Dollars per peso)
Summarize the results of capital flight by completing the following table.
Real Interest Rate Real Exchange Rate Net Capital Outflow
Points: 0.33 / 1
Effects of capital flight Increase Decrease Increase
Explanation: Close Explanation
Capital flight results in an increase of net capital outflow for any given real interest rate, which causes the demand for
loanable funds to increase. This puts upward pressure on the real interest rate and results in a higher level of net capital
outflow. Because the supply curve in the foreign-currency exchange market is equal to the level of net capital outflow, this
curve also shifts rightward. This causes the real exchange rate for pesos to decrease (the peso depreciates), which makes
Mexican goods and services more attractive in the international market, which then causes an increase in net exports. [Show Less]