In this lesson summary review and remind yourself of the key terms and graphs related to how relative differences in real interest rates change the flow of assets between countries.
There is more to international exchange than the flow of goods and services across borders: financial assets are also exchanged. When there are differences in real interest rates between two countries that allow for the flow of financial capital, that capital flows to the country with the relatively higher real interest rate and out of the country with the relatively lower real interest rate.
This has a few important implications. First, differences in real interest rates affect the balance of payments, exchange rates, and the market for loanable funds. Second, since central banks can influence the domestic interest rate (at least in the short run), they can also affect capital flows. Finally, and perhaps most importantly, this means that one country’s business cycle can affect another country, which is why we sometimes see recessions and financial crises spread between countries.
Key Terms
| Key Term | Definition |
|---|---|
| capital controls | legal restrictions on the movement of capital between countries |
| financial contagion | the spread of economic conditions, especially negative market disturbances, from one country to another; For example, a recession in Hamsterville has a negative effect on the economy of Johnsrudia. |
Key takeaways
Financial capital flows to the highest real interest rate
An open economy lacks capital controls, and when there are no controls on the movement of financial assets, people will be attracted to assets with higher real interest rates.
Imagine you are a resident of Hamsterville, lying on the beach while reading an international financial newspaper. You see that interest rates in Johnsrudia have increased from 2% to 6% because high investment demand has increased the demand for loanable funds. You remember your broker was going to buy $10,000 worth of Hamsterville bonds being issued today, on which you expected only a 3% return. You frantically call her and tell her to buy assets in Johnsrudia instead.
What effect does this have? A lot! First, you just reduced the supply of loanable funds in Hamsterville, which increases real interest rates in Hamsterville. Second, Johnsrudia is going to require you to buy assets there using their currency, the Johnsrudian Walter. The supply of dollars increases, which depreciates the dollar, and the demand for the Johnsrudian Walter increases, which appreciates the Walter.
Central banks can influence the movement of capital, exchange rates, and net exports
Central banks can influence the movement of capital because they can influence interest rates in the short run. Suppose instead you read that the central bank of Hamsterville has bought bonds, lowering the domestic nominal interest rate. Well, the effect would be the same! Now your rate of return domestically is less than it is internationally, so you send your savings elsewhere.
Expansionary monetary policy and expansionary fiscal policy can potentially impact the exchange rate in different ways
Recall that expansionary monetary policy and expansionary fiscal policy both had the same goal: increase aggregate demand and output and decrease the unemployment rate. However, each of these has the opposite impact on interest rates in the short run, which means they also have opposite effects on exchange rates.
Let’s walk through the chain of events that occur with expansionary monetary policy:
- The central bank buys bonds.
- This increases the money supply
- This decreases the interest rate:
- A decrease in interest rates makes assets in this country less attractive to investors from other countries. Demand for these assets decreases, which means other countries will need less of this country's currency to buy its assets, so the demand for this country's currency decreases. At the same time, people in this country will want to buy more of another country's assets. To do so, this country will have to supply more of its currency. Therefore, the demand for this country’s currency will decrease and its supply will increase:
The decrease in demand and increase in supply causes the currency to depreciate. Now, it’s exports are relatively cheaper for other countries, so its net exports increase.
We can keep track of this chain of events using this shorthand (read “→” as “leads to”) :
M_s ↑ → int rate ↓ → Dcurrency ↓ & Scurrency ↑→ ER ↓ → NX ↑ → AD ↑
Let’s also take a look at the chain of events that occur when expansionary fiscal policy leads to an increase in interest rates:
- Expansionary fiscal policy (increasing government spending or decreasing taxes) results in a budget deficit
- The government borrows money to pay for that deficit, which increases the demand for loanable funds. The increase in loanable funds increases the interest rate:
The appreciation in the currency makes goods from this country relatively more expensive. As a result, net exports decrease.
We can keep track of this chain of events using this shorthand (read “→” as “leads to”) :
Govt spending and deficit ↑ → int. rate↑ → Dcurrency ↑ → ER ↑ → NX ↓ → AD ↓
Common Misperceptions:
Capital vs. Financial Capital
Capital and financial capital are not the same! Anytime you talk about the movement of “capital”, you should be careful to specify which you are talking about. The movement of capital between countries would be something like computer equipment or tractors being purchased from another country. The movement of financial capital is sending savings to another country.
Questions for Review
The government of Frankland increased government spending to combat a recession. Assume that the budget was balanced prior to the increase in government spending.
(a) What is the effect of an increase in government spending on the market for loanable funds? Explain.
(b) What is the effect of the change in interest rates based on your answer to (a) on Frankland’s capital flows and financial account? Explain.
(c) What effect does the change in capital flows described in part (b) on Frankland’s exchange rate? Explain.
(d) How does the change in exchange rates in part (c) affect Frankland’s net exports? Explain.
(e) How does the change in capital flows in part (c) affect the market for loanable funds? Explain.
(a) The demand for loanable funds increases and the real interest rate increases. An increase in government spending leads to a budget deficit, and budget deficits increase the demand for loanable funds.
(b) Financial capital flows to Frankland and the financial account increases. Financial capital flows to Frankland because the interest there is now relatively higher than in other countries. When financial capital enters a country, it is counted as a credit in that country’s financial account.
(c) Frankland’s currency appreciates. In order to buy Frankland’s assets, foreign investors will need to buy its currency. The demand for Frankland’s currency increases, causing the currency to appreciate.
(d) Net exports decrease. A higher exchange rate makes Frankland’s exports relatively more expensive and imports relatively less expensive, decreasing net exports.
(e) The supply of loanable funds decreases, decreasing the interest rate. When foreign financial capital enters Frankland, this adds to the country’s supply of loanable funds. When the supply of loanable funds increases, the real interest rate decreases.
