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Interest Rates &
International Capital Flows

Explore how real interest rate differentials drive capital across borders, shape exchange rates, and influence the balance of payments.

AP Macroeconomics

What Are Capital Flows?

International capital flows are movements of money across borders for the purpose of investment. When investors seek higher returns, they move financial capital: purchasing foreign bonds, stocks, or real assets.

Capital Inflow
Foreign money enters a country: foreigners buy domestic assets, lend to domestic borrowers, or invest in domestic firms.
Capital Outflow
Domestic money exits a country: domestic investors buy foreign assets, lend abroad, or invest in foreign firms.

Nominal vs. Real Interest Rates

The nominal interest rate is the stated rate on a loan or bond. The real interest rate adjusts for inflation, revealing the true return to lenders and true cost to borrowers.

Why Real Rates Matter
Investors compare real returns across countries. A 10% nominal rate with 8% inflation yields only a 2% real return.
International Context
Capital flows respond to real interest rate differentials, not nominal ones, because investors care about purchasing power.

Why Differentials Drive Capital

Investors are rational: they seek the highest risk-adjusted real return. When one country's real interest rate rises relative to another's, capital flows toward the higher-return country.

Country A High real rate
\(r = 5\%\)
 Country B Low real rate
\(r = 1\%\)
 Capital Inflow Country A's currency APPRECIATES

The Core Rule

Chain of Causation

Real Interest Rate \(\uparrow\)
Capital Inflows \(\uparrow\)
Demand for Domestic Currency \(\uparrow\)
 Domestic Currency Appreciates
Net Exports \(\downarrow\)

Financial Account vs. Current Account

The balance of payments has two main accounts. They are mirror images: a surplus in one means a deficit in the other.

Financial Account Current Account
Records Capital flows (asset purchases) Trade in goods, services, income
Surplus means Net capital inflow Net exports > imports
Deficit means Net capital outflow Net imports > exports
Key identity \(\text{Financial Account} + \text{Current Account} = 0\)

Loanable Funds in an Open Economy

In a closed economy, the real interest rate is set where domestic saving equals domestic investment. In an open economy, foreign capital fills any gap between national saving and investment.

Quantity of Loanable Funds Real Interest Rate S (Saving) D (Investment)
\(Q^*\)
\(r^*\)
\(r_w\)
 Capital Inflow

How to Apply the Model

1
Identify the policy or shock. Did the central bank raise rates? Did the government increase borrowing? Did inflation expectations change?
2
Determine the effect on real interest rates. Use \( r = i - \pi^e \). Did the real rate rise or fall relative to other countries?
3
Trace the capital flow. Higher domestic \( r \) attracts inflows; lower \( r \) causes outflows.
4
Follow through to the currency. Inflows increase demand for domestic currency (appreciation). Outflows increase supply (depreciation).
5
Conclude with net exports. Appreciation hurts net exports; depreciation helps them.

Example 1: Fed Raises Rates

Scenario: The Federal Reserve raises the federal funds rate. Expected inflation remains unchanged. Other countries' rates are unchanged.

1
Real interest rate in the U.S. rises. Since \( i \) increases but \( \pi^e \) is constant, \( r = i - \pi^e \) rises.
2
Capital flows into the U.S. Foreign investors seek the higher real return on U.S. assets.
3
Demand for U.S. dollars increases in the foreign exchange market. The dollar appreciates.
4
U.S. net exports decrease. A stronger dollar makes U.S. exports more expensive and imports cheaper.

Example 2: Government Budget Deficit

Scenario: The government increases spending, financed by borrowing. This increases demand for loanable funds, pushing the domestic real interest rate up.

Q of Loanable Funds Real Interest Rate
\(S\)
\(D_1\)
\(D_2\)
\(r_1\)
\(r_2\)
 Shift

Example 3: Rising Inflation Expectations

Scenario: Expected inflation in Country X rises from 2% to 6%, while the nominal rate stays at 7%. Other countries' real rates are unchanged.

Before
\( r = 7\% - 2\% = 5\% \)
After
\( r = 7\% - 6\% = 1\% \)
1
Real rate drops from 5% to 1%, even though the nominal rate did not change.
2
Capital flows out of Country X as investors seek higher real returns elsewhere.
3
Country X's currency depreciates, and its net exports rise.

The Forex Market Connection

Q of Domestic Currency Exchange Rate (Foreign/Domestic)
\(S_\$\)
\(D_1\)
\(D_2\)
\(e_1\)
\(e_2\)
 Appreciation

Net Capital Outflow and \( r \)

Net capital outflow (NCO) is inversely related to the domestic real interest rate. As \( r \) rises, NCO falls (more inflow, less outflow).

\(NCO\)
Real Interest Rate (\(r\))
\(NCO\)
 0 Capital Inflow Capital Outflow
High \(r\)
Low \(r\)

Common Mistakes

✕ Confusing Nominal and Real
Students compare nominal rates across countries. Capital responds to real interest rate differences. Always subtract expected inflation first.
✕ Reversing the Currency Effect
A capital inflow increases demand for the currency, causing appreciation, not depreciation. Think: foreigners must buy your currency to invest.
✕ Ignoring the Accounts Identity
The financial account and current account must sum to zero. A financial surplus means a current account deficit, not a surplus.

Summary Table

Shock Real Rate Capital Flow Currency Net Exports
Central bank raises rates ↑ Inflow ↑ Appreciates ↓
Gov't budget deficit ↑ ↑ Inflow ↑ Appreciates ↓
Inflation expectations ↑ ↓ Outflow ↑ Depreciates ↑
Central bank lowers rates ↓ Outflow ↑ Depreciates ↑

Question 1 of 5

If the U.S. real interest rate rises relative to the rest of the world, what happens to the value of the U.S. dollar?

Question 2 of 5

Country Z has a nominal interest rate of 8% and expected inflation of 5%. Country W has a nominal rate of 4% and expected inflation of 1%. In which direction will capital flow?

Question 3 of 5

A country experiences a financial account surplus. What must be true about its current account?

Question 4 of 5

If expected inflation in a country increases while its nominal interest rate remains constant, what happens to net capital outflow?

Question 5 of 5

The government of Country M runs a large budget deficit, pushing up the real interest rate. Which of the following is the most likely outcome?