I n t h I s c h a p t e r y o u w I l L

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 loan-
able 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 
S
1
to 
S
2
in panel (a) of Figure 30-5.
Our third and final step is to compare the old and new equilibria. Panel (a)
shows the impact of a U.S. budget deficit on the U.S. market for loanable funds.
With fewer funds available for borrowers in U.S. financial markets, the interest
rate rises from 
r
1
to 
r
2
to balance supply and demand. Faced with a higher interest
rate, borrowers in the market for loanable funds choose to borrow less. This
change is represented in the figure as the movement from point A to point B along
the demand curve for loanable funds. In particular, households and firms reduce
their purchases of capital goods. As in a closed economy, budget deficits crowd out
domestic investment.
In an open economy, however, the reduced supply of loanable funds has addi-
tional effects. Panel (b) shows that the increase in the interest rate from 
r
1
to 
r
2
re-
duces net foreign investment. [This fall in net foreign investment is also part of the
decrease in the quantity of loanable funds demanded in the movement from point
A to point B in panel (a).] Because saving kept at home now earns higher rates of
return, investing abroad is less attractive, and domestic residents buy fewer for-
eign assets. Higher interest rates also attract foreign investors, who want to earn
the higher returns on U.S. assets. Thus, when budget deficits raise interest rates,
both domestic and foreign behavior cause U.S. net foreign investment to fall.
Panel (c) shows how budget deficits affect the market for foreign-currency ex-
change. Because net foreign investment is reduced, people need less foreign cur-
rency to buy foreign assets, and this induces a leftward shift in the supply curve
for dollars from 
S
1
to 
S
2
. The reduced supply of dollars causes the real exchange
rate to appreciate from 
E
1
to 
E
2
. That is, the dollar becomes more valuable com-
pared to foreign currencies. This appreciation, in turn, makes U.S. goods more ex-
pensive compared to foreign goods. Because people both at home and abroad
switch their purchases away from the more expensive U.S. goods, exports from the
United States fall, and imports into the United States rise. For both reasons, U.S.
net exports fall. Hence, 
in an open economy, government budget deficits raise real inter-
est rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade
balance toward deficit.

---

C H A P T E R 3 0
A M A C R O E C O N O M I C T H E O R Y O F T H E O P E N E C O N O M Y
6 8 9
An important example of this lesson occurred in the United States in the 1980s.
Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of
the U.S. federal government changed dramatically. The president and Congress
enacted large cuts in taxes, but they did not cut government spending by nearly as
(a) The Market for Loanable Funds
(b) Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r
1
r
1
E
1
E
2
Demand
Demand
r
2
r
2
NFI
S
1
S
2
S
2
S
1
B
A
1. A budget deficit reduces
the supply of loanable funds . . . 
2. . . . which 
increases
the real 
interest
rate . . . 
4. The decrease
in net foreign
investment reduces
the supply of dollars
to be exchanged
into foreign
currency . . . 
5. . . . which 
causes the
real exchange 
rate to
appreciate.
3. . . . which in
turn reduces
net foreign
investment.
F i g u r e 3 0 - 5
T
HE
E
FFECTS OF A
G
OVERNMENT
B
UDGET
D
EFICIT
. When the government runs a budget
deficit, it reduces the supply of loanable funds from 
S
1
to 
S
2
in panel (a). The interest rate
rises from 
r
1
to 
r
2
to balance the supply and demand for loanable funds. In panel (b), the
higher interest rate reduces net foreign investment. Reduced net foreign investment, in
turn, reduces the supply of dollars in the market for foreign-currency exchange from 
S
1
to
S
2
in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate
from 
E
1
to 
E
2
. The appreciation of the exchange rate pushes the trade balance toward
deficit.

---

6 9 0
PA R T E L E V E N
T H E M A C R O E C O N O M I C S O F O P E N E C O N O M I E S
much, so the result was a large budget deficit. Our model of the open economy
predicts that such a policy should lead to a trade deficit, and in fact it did, as we
saw in a case study in the preceding chapter. The budget deficit and trade deficit
during this period were so closely related in both theory and practice that they
earned the nickname the 
twin deficits.
We should not, however, view these twins as
identical, for many factors beyond fiscal policy can influence the trade deficit.
T R A D E P O L I C Y
A