Question

Use the demand-and-supply of foreign currency graph to determine what would happen to a small, open economy that experienced capital outflows.

Short answer

The demand for the country's currency would decline, as would the exchange rate.

Step-by-step solution

Step 1. Introduction

The market for foreign exchange is a market structure or system in which the exchange of currencies takes place. the demand for currencies works in the same way as the demand for products in the goods market. The supply of currency can however be controlled by the government.

Step 2. Explanation

If an outflow of funds takes place, it means that capital from the domestic economy is being invested in some other country. To invest in a foreign country, the foreign currency would be required, which would be acquired through exchange. So, the demand for domestic currency would decline and that of foreign currency would increase. As the demand curve for domestic currency moves to the left, the value of currency would depreciate.