When we first discussed the supply and demand for loanable funds earlier in the book, we examined the effects of government budget deficits, which occur when government spending exceeds government revenue. Because a government budget deficit represents negative public saving, it reduces national saving (the sum of public and private saving). Thus, a government budget deficit reduces the supply of loanable funds, drives up the interest rate, and crowds out investment. Now let’s consider the effects of a budget deficit in an open economy. First, which curve in our model shifts? As in a closed economy, the initial impact of the budget deficit is on national saving and, therefore, on the supply curve for loanable funds. Second, which way does this supply curve shift? Again as in a closed economy, a budget deficit represents negative public saving, so it reduces national saving and shifts the supply curve for loanable funds to the left. This is shown as the shift from SI to S2 in panel (a) of Figure 5. Figure 5 The Effects of a Government Budget Deficit When the government runs a budget deficit. it reduces the supply of loanable funds from 51 to 5z in panel (a) .. The interest rate rises from ‘Ito rz to balance the supply and demand for loanable funds. In panel (b), the higher interest rate reduces net capital outflow. Reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency exchange from 51 to 5z in panel (c). This  in the supply of dollars causes the real exchange rate to appreciate from £j to £2’ The appreciation of the exchange rate pushes the trade balance toward deficit.

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