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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