First the identity:

Investment = Private Saving + Public Saving + Net Capital Inflow ( I = S – NCO)

 

So with private saving low and public saving negative (Taxes minus Government Spending), the only way for the U.S. to keep investment high is for foreign saving to be high (NCO<0 - Net Capital Outflow is negative or a Net Capital Inflow to the U.S.A.).  (Also note, S is National Saving or Public + Private.)

 

      I + NCO is the Demand for Loanable Funds – shift left (or decrease), which decreases the real interest rate.  The decrease in the real interest rate is a counter to the large U.S. budget deficits or public saving. (I'll leave the graphs to you.)

 

With public saving negative – the Supply of Loanable Funds shifts left so the real interest rate can remain unchanged (relatively) and the real exchange rate also will not change much – fixed yuan/$!  (Remember real means adjusted for inflation.)

 

Why won’t the real exchange rate change much?  Because the nominal exchange rate is “pegged” to the U.S. dollar at the moment (6.83 yuan/$1).  So only relative inflation rates will adjust the real exchange rate.  The U.S. and China currently have very little inflation or deflation and thus the real exchange rate is almost fixed too.

 Laughing out loud - no worries if you don't follow totally.  I gave the students the question two weeks before the final exam, if you were wondering.  Yes, just like when YOU were a student, many procrastinated!!  Still I was relatively easy on the grading!