The second and third effects explain why the supply of credit slopes upward in Figure 14.17 “Crowding Out”. As a result, the decrease in investment is not as large as the increase in the deficit. The decrease in government saving is partly offset by an increase in private saving and an increase in borrowing from abroad. Increased borrowing from abroad must result in a decrease in net exports to keep the flows into and from the foreign sector in balance. To understand these linkages, imagine that the United States sells additional government debt, some of which is purchased by banks in Europe, Canada, Japan, and other countries. These purchases of government debt require transactions in the foreign exchange market. If a bank in Europe purchases US government debt, there is an increased demand for dollars in the euro market for dollars, which leads to an appreciation in the price of the dollar. When the dollar appreciates, US citizens find that European goods and services are cheaper, whereas Europeans find that US goods and services are more expensive. US imports increase and exports decrease, so net exports decrease.
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