POLITICAl INSTABILITY AND CAPITAL FLIGHT
In 1994, political instability in Mexico, including the assassination of a prominent political world financial markets nervous. People began to view Mexico as a much less stable country than they had previously thought. They decided to pull some of their assets out of Mexico to move these funds to the United States and other “safe havens.” Such a large and sudden movement of funds out of a country is called capital flight. To see the implications of capital flight for the Mexican economy, we again follow our three steps for analyzing a change in equilibrium, but this time, we apply our model of the open economy from the perspective of Mexico rather than the United States. Consider first which curves in our model capital flight affects. When investors around the world observe political problems in Mexico, they decide to sell some of their Mexican assets and use the proceeds to buy US. assets, This act increases Mexican net capital outflow and, therefore, affect markets in our model. Most obviously, it affects the net-capital-outflow curve, and this in turn influences the supply of pesos in the market for foreign-currency exchange. In addition, because the demand for loanable funds comes from both domestic investment and net capital outflow, capital flight affects the demand curve in the market for loanable funds.
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