6.6 Real Interest Rates and International Capital Flows

Real Interest Rates Drive Capital Flows

Financial capital moves toward countries offering the highest real interest rates (nominal rate minus inflation), since investors seek the best real return. If U.S. real interest rates rise relative to other countries, foreign investors increase financial capital inflow into U.S. assets like bonds, seeking higher returns.

Loanable Funds Market Sets the Real Rate

The loanable funds market shows demand (borrowers) and supply (savers) of funds, determining the equilibrium real interest rate. Factors like government borrowing (deficits) shift demand right, raising real interest rates. Increased private saving or foreign capital inflow shifts supply right, lowering real interest rates.

Linking Capital Flows to Currency Markets

A rise in a country's real interest rate increases net capital inflow, raising demand for its currency in the foreign exchange market, causing it to appreciate. Currency appreciation makes exports more expensive and imports cheaper, decreasing net exports. This connects the loanable funds market to the forex market and trade balance.

Key terms

Real interest rate

Nominal interest rate minus inflation rate; the true return on savings or cost of borrowing.

Loanable funds market

Market where the supply of savings meets the demand for borrowing, determining the equilibrium real interest rate.

Financial capital inflow

Foreign purchases of a country's assets (bonds, stocks); increases when domestic real interest rates rise relative to other countries.

Effect of higher real interest rates on currency

Increases demand for the currency in forex markets, causing appreciation.

Effect of currency appreciation on net exports

Decreases net exports because exports become more expensive and imports become cheaper.

Try an AP-style question

If U.S. real interest rates rise relative to other countries, financial capital…

1. flows out of the U.S.
2. flows only to Europe
3. flows into the U.S.
4. stops moving