Qusetion: a) Assume that the government is already running a deficit and decides to cut taxes for individuals as a part of its plan to deal with an ongoing recession. Explain and show on a diagram how such a policy would affect the market for loan able funds. Would an increase in government borrowing affect private investment?
b) The "twin deficit" idea is that, usually, budget deficits are accompanied with trade deficits. Using the discussion in the textbook of the market for USD in Section 31.3 ("How Government Borrowing Affects Private Saving"), draw a well-labeled figure of the foreign exchange market for USD and show on your diagram what you would expect to happen to the equilibrium "price (i.e. the exchange rate of USD) if the government increases borrowing. Explain the logic behind the change you draw
c) Based on your answer in (d), do US exports get cheaper or more expensive? What do you predict would happen to the trade balance if the US government increases its borrowing?
d) Write down the identity that links net capital outflows and net exports. Show that you can write total savings as the sum of public savings (T-G) and private savings (Y-T-C). Explain whether your answer to (e) is consistent with this identity (that net capital outflow is equal to net exports).