1. If the government budget deficit rises, what happens to the interest rate?

What does this

A government budget deficit indicates that the government is spending more than it
receives from tax revenue. When the government budget deficit rises, it reduces national saving,
since a budget deficit represents negative public saving. Furthermore, a negative public saving
reduces the supply of loanable funds in the market, shifting the supply curve for loanable funds
to the left, from point S1 to S2 on the market for loanable funds graph (figure 1). With a lower
supply of loanable funds in the market and unchanged demand, the equilibrium interest rate in
the economy increases, going from point A to point B (figure 1). The increase in interest rate
could be explained by the fact that banks would attempt to encourage more people to save by
offering a higher interest rate in return.

Moving on, a higher interest rate causes a reduction in net capital outflow, meaning that
the movement of assets out of the country reduces, going from point A to point B on the net
capital outflow graph (figure 1). This is because a higher interest rate makes domestic
investments more appealing, encouraging domestic residents to keep their assets within the
country instead of sending their capital abroad since they could earn higher returns at home,
which reduces the movement of assets out of the country. On top of that, high interest rates also
increase the incentives for foreign investors to buy domestic assets, which increases the amount
of assets flowing into the country, consequently reducing the net capital outflow of the country. It
is also important to note that net capital outflow is determined by domestic residents investing in
foreign assets less foreigners investing in domestic assets. Therefore, when less assets are
flowing out of the country and more foreign assets are flowing into the country due to the high
interest rate, it reduces net capital outflow.

Figure 1 - The Market for Loanable Funds (left) & Net Capital Outflow (right)

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2. Other things the same, which curve in the market for foreign-currency exchange shifts
and which direction does it shift if net capital outflow rises?

The market for foreign-currency exchange graph consists of real exchange rate as the
Y-axis and quantity of a country currency as the X-axis. The supply curve represents net capital
outflow, and is vertical because net capital outflow only impacts the quantity of a country’s
currency in the market and isn’t affected by the real exchange rate of the currency. On the other
hand, The demand curve represents net exports and is downward sloping, meaning that as the
real exchange rate decreases (moving down the vertical axis), the quantity of dollars demanded
increases (moving right on the horizontal axis). This is because when a country’s currency
depreciates for example, This is because when a country's currency depreciates for example, its
goods and services become relatively cheaper for foreign buyers. This makes the country's
exports more attractive and competitive in international markets, while also making imports
more expensive for domestic consumers.

To answer the question, when net capital outflow rises, it means that there are more
domestic residents investing in foreign assets rather than foreigners investing in domestic assets.
This indicates that more of the domestic currency is being supplied to the foreign exchange
market to purchase foreign currencies for these investments. For this reason being, it shifts the
supply curve to the right from S1 to S2 (figure 2), because the supply curve in the foreign
exchange market represents the quantity of domestic currency being offered for exchange. A
higher net capital outflow means a larger quantity of domestic currency is being supplied to buy
foreign currencies at any given exchange rate. This shift reflects the increased willingness of
domestic investors to supply their currency to the foreign exchange market in order to acquire
foreign assets, which results in a higher supply of the domestic currency at all exchange rates.

Figure 2 - The Market for Foreign-Currency Exchange

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3. A country reduces its government budget deficit and also makes political reforms that
lead people to believe this country’s assets are less risky. Given the combination of a
reduced deficit and lower asset risk, what happens to the interest rate?

A country could reduce its government deficit by reducing its spending relative to its tax
revenue or increasing its tax revenue relative to its spending. With a decrease in government
budget deficit, it allows private sectors to save more since they are not competing as much with
the government for funds, which increases the national saving. With more people saving, it
increases the supply for loanable funds in the market, shifting the supply curve of loanable funds
to the right, from S1 to S2 (figure 3).

Additionally, when the government makes political reforms that lead people to believe
this country’s assets are less risky, it makes the country’s assets more appealing for both
domestic residents and foreigners. For this reason being, more domestic residents are more likely
to invest in domestic assets rather than investing abroad, which reduces the net capital outflow.
On top of that, foreigners also have more incentives to invest in the country’s assets, increasing
capital inflow, which decrease the net capital outflow of the country. Overall, a better political
stability decreases the net capital outflow of the country, and if less money is flowing out of the
country to buy foreign assets, there's less overall demand for funds to borrow, which reduces the
demand for loanable funds, shifting the demand curve of loanable funds to the left, from D1 to
D2 (figure 3).

Generally speaking, given the combination of a reduced deficit and lower asset risk, it
increases the supply and decreases the demand for loanable funds. With the supply curve shifting
to the right and the demand curve shifting to the left, it leads to a lower equilibrium interest rate,
going from point A to point B (figure 3). Note that although, the shifts of both the supply and
demand curve depends on its relative sizes of the shifts and the elasticities of the curves, it would
lead to a lower interest rate.

Figure 3 - The Market for Loanable Funds