Unit 6 · Topic 6.6

Real Interest Rates and International Capital Flows

Relative real interest rates steer financial capital between countries.

Practice 2: InterpretationPractice 3: ManipulationPractice 4: Graphing and Visuals

Part 1 · Hook

Why this matters

A pension fund in Tokyo, an insurer in London and a family in Toronto can all buy US Treasury bonds with a few clicks. When US real interest rates rise compared with rates at home, many of them do. To buy those bonds they first have to buy dollars, and that one decision runs through three markets: loanable funds, the currency market and trade.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. A government borrows more to fund a budget deficit. In its loanable funds market, what happens?

  1. Demand for loanable funds shifts right and the real interest rate rises
  2. Supply of loanable funds shifts right and the real interest rate falls
  3. Demand shifts left and the real interest rate falls
  4. Nothing, because government borrowing is not lending
Show the answer

Government borrowing adds to the demand for loanable funds, raising the real interest rate.

  • Correct: Demand for loanable funds shifts right and the real interest rate rises:
  • Supply of loanable funds shifts right and the real interest rate falls:
  • Demand shifts left and the real interest rate falls:
  • Nothing, because government borrowing is not lending:

2. US real interest rates rise relative to Europe's. In the market for dollars, what happens?

  1. Demand for dollars rises and the dollar appreciates
  2. Supply of dollars rises and the dollar depreciates
  3. Demand for dollars falls and the dollar depreciates
  4. Nothing, because interest rates are not traded
Show the answer

Savers abroad buy dollars to buy US bonds, so demand for dollars rises.

  • Correct: Demand for dollars rises and the dollar appreciates:
  • Supply of dollars rises and the dollar depreciates:
  • Demand for dollars falls and the dollar depreciates:
  • Nothing, because interest rates are not traded:

3. A country has a capital and financial account surplus of 50. What is its current account balance?

  1. -50
  2. +50
  3. 0
  4. +100
Show the answer

The two balances sum to zero, so the current account balance is -50.

  • Correct: -50:
  • +50:
  • 0:
  • +100:

Part 4 · See it

See it first

Two linked graphs. Left: the US loanable funds market, with Quantity of loanable funds and Real interest rate on the axes; demand for loanable funds shifts right from DLF1 to DLF2 along supply SLF, and the real interest rate rises from r1 to r2. An arrow says the real rate rises above Europe's and financial capital flows into the US. Right: the market for dollars, with Quantity of dollars and Price of the dollar (euros per dollar); demand shifts right from D1 to D2 and the exchange rate rises from XR1 to XR2. Below, the chain: government borrowing rises, the real interest rate rises, capital flows in as foreigners buy US assets, demand for dollars rises, the dollar appreciates, net exports fall. The inflow is a larger capital and financial account surplus, matched by a smaller current account balance.
More US government borrowing raises the US real interest rate (loanable funds), financial capital flows in, demand for dollars rises and the dollar appreciates, so net exports fall. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. A country's real interest rate rises relative to other countries' (for example, its government borrows more)its assets pay savers a higher real return than assets abroad
  2. Savers abroad move funds toward the higher real returnfinancial capital flows in, and the capital and financial account balance rises
  3. Savers abroad need the country's currency to buy its assetsthe demand for its currency rises, so the currency appreciates
  4. The currency appreciatesexports cost more abroad and imports cost less at home, so net exports and the current account balance fall

Part 6 · Key ideas

Key ideas

  • Financial capital flows toward the country with the higher real interest rate, other things equal: savers compare returns after expected inflation.
  • A capital inflow raises the capital and financial account balance and the demand for the currency, so the currency appreciates and net exports fall. The current account balance falls by the same amount, keeping the sum at zero.
  • The inflow also adds to the supply of loanable funds in the receiving country, which holds down its real interest rate; in the sending country, the supply of loanable funds falls.
  • Lower relative real rates, as after expansionary monetary policy, send capital out: the currency depreciates and net exports rise.

Part 7 · Misconception

A common mistake

The wrong idea: Financial capital flows toward the country with the higher nominal interest rate.

What actually happens: Savers compare real returns: nominal rate minus expected inflation. A country paying 7% with 4% expected inflation (3% real) draws less than one paying 5% with 1% expected inflation (4% real).

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

Graph

Arland's loanable funds market after its government borrows more (Arland and its trading partner Belvia are invented)

Quantity of loanable fundsReal interest rateDLF1DLF2SLFQr

1. What happened to Arland's real interest rate?

  1. It fell, because more funds were lent
  2. It rose, because the demand for loanable funds increased
  3. It did not change, because supply did not shift
  4. It rose, because the supply of loanable funds shifted left
Show the answer

Demand for loanable funds right: the real interest rate rises.

  • It fell, because more funds were lent: The demand for loanable funds rose, which raises the real interest rate along the supply curve.
  • Correct: It rose, because the demand for loanable funds increased: Right: government borrowing shifted the demand for loanable funds right, so the real interest rate rose.
  • It did not change, because supply did not shift: A shift in demand alone moves the equilibrium along the supply curve, changing the rate.
  • It rose, because the supply of loanable funds shifted left: The graph shows demand shifting right; supply did not move.

2. Belvia's real interest rate does not change. Which way does financial capital flow?

  1. From Belvia into Arland
  2. From Arland into Belvia
  3. It does not flow, because the change was in government borrowing
  4. It flows both ways equally, so there is no net flow
Show the answer

Financial capital flows toward the higher relative real interest rate.

  • Correct: From Belvia into Arland: Right: Arland assets now pay a higher real return than Belvian ones, so savers move funds into Arland, a capital inflow for Arland.
  • From Arland into Belvia: Savers move toward the higher real return, which is now in Arland.
  • It does not flow, because the change was in government borrowing: The cause does not matter to savers; the higher real return does.
  • It flows both ways equally, so there is no net flow: The gap in real interest rates makes the net flow go toward Arland.

3. What happens in the market for arls?

  1. The supply of arls rises, and the arl depreciates
  2. The demand for arls falls, and the arl depreciates
  3. The demand for arls rises, and the arl appreciates
  4. Nothing, because loanable funds are not currency
Show the answer

The capital inflow raises demand for arls: the arl appreciates.

  • The supply of arls rises, and the arl depreciates: Foreign savers buying Arland assets need arls: they demand arls, they do not supply them.
  • The demand for arls falls, and the arl depreciates: More foreign savers want Arland assets, so demand for arls rises.
  • Correct: The demand for arls rises, and the arl appreciates: Right: to buy Arland assets, Belvian savers need arls, so demand for arls shifts right and the arl appreciates.
  • Nothing, because loanable funds are not currency: The funds come from abroad, so they must be changed into arls first.

4. Following the chain from the loanable funds market, what happens to Arland's net exports, other things equal?

  1. They rise, because more funds flow into Arland
  2. They do not change, because the flow is in the financial account
  3. They rise, because the arl appreciates
  4. They fall, because the arl appreciates
Show the answer

Higher real rate, capital inflow, demand for arls, appreciation, lower net exports.

  • They rise, because more funds flow into Arland: The inflow is in the capital and financial account; through the stronger arl it lowers net exports.
  • They do not change, because the flow is in the financial account: The appreciation of the arl changes the prices that foreign and Arland buyers face, which changes trade.
  • They rise, because the arl appreciates: An appreciation makes Arland exports dearer abroad and imports cheaper, so net exports fall.
  • Correct: They fall, because the arl appreciates: Right: the stronger arl makes Arland goods cost more bels and Belvian goods fewer arls, so exports fall, imports rise and net exports fall.

5. Arland's real interest rates rise relative to Belvia's, and financial capital flows into Arland. Draw the market for arls: label it, shift a curve and mark the new equilibrium.

???1?2

Work on the graph (it needs JavaScript), then check.

Show the answer

Belvian savers need arls to buy Arland assets, so the demand for arls shifts right and the arl appreciates (Arland savers keeping their funds at home, the supply of arls shifting left, is also accepted). The vertical axis is the price of the arl: bels per arl.

  • Key: demand shifts right

6. Foreign residents buy 90 billion arls more of Arland's assets than Arland residents buy of foreign assets this year. Which must be true of Arland's current account?

  1. It has a surplus of 90 billion arls
  2. It is balanced, because asset trades are not in the current account
  3. It has a deficit of 90 billion arls
  4. It equals Arland's government budget deficit
Show the answer

A capital and financial account surplus of 90 means a current account deficit of 90.

  • It has a surplus of 90 billion arls: The two balances sum to zero, so a capital and financial account surplus of 90 is matched by a current account deficit of 90.
  • It is balanced, because asset trades are not in the current account: Asset trades are not in the current account, but the two balances still sum to zero, so the current account is in deficit.
  • Correct: It has a deficit of 90 billion arls: Right: the net inflow is a capital and financial account surplus of 90, so the current account balance is -90.
  • It equals Arland's government budget deficit: The budget balance is not part of the balance of payments.

Part 9 · Summary

Summary

Relative real interest rates steer financial capital between countries. When one country's real rate rises above others', savers abroad buy its assets: financial capital flows in, its capital and financial account balance rises, the demand for its currency rises and the currency appreciates, so its net exports and current account balance fall. The inflow also adds to its supply of loanable funds. Write the whole chain, link by link, and use the real interest rate.

Part 10 · Up next

What comes next

This is the last topic in the course.

Part 11 · Connections

Connections

Question set for this topic