AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/6/6-6)
Unit 6 · Topic 6.6
6.6 Real Interest Rates and International Capital Flows
Financial capital (money looking for a good return) flows toward countries where real interest rates are relatively high. Those flows change the demand for and supply of currencies, so they move exchange rates. They also shift the supply of loanable funds in the countries that send and receive the money.
Key terms
- capital inflow
- capital outflow
- real interest rate differential
- financial capital
- currency appreciation
- loanable funds market
Why capital flows toward higher real rates
Financial capital is money used to buy financial assets such as bonds, stocks and bank deposits. Investors compare returns across countries. If U.S. real interest rates rise compared with Japan's, U.S. bonds become more attractive, so investors buy more U.S. assets. That's a capital inflow for the U.S. and a capital outflow for Japan.
Investors compare real rates, not nominal ones, because they care about what their returns will buy after inflation. Other things matter too, such as risk: investors may accept a lower return in a country they see as safer. AP questions usually hold those things constant and focus on the real interest rate.
Effect on the foreign exchange market
When U.S. real interest rates rise relative to Japan's, both currency markets change. After that, topic 6.5 takes over: the stronger dollar lowers U.S. net exports. A net capital inflow also shows up as a capital and financial account surplus (6.1).
- Market for dollars: foreign investors need dollars to buy U.S. assets, so demand for dollars shifts right. Americans have less reason to buy foreign assets, so the supply of dollars can shift left too. The dollar appreciates.
- Market for yen: Japanese investors supply more yen to get dollars, so the supply of yen shifts right and the yen depreciates.
Effect on the loanable funds markets
A capital inflow is extra money available to U.S. borrowers. In an open economy, investment = national saving + net capital inflow (4.7). Draw each country's loanable funds market with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. As capital moves, the gap between the two countries' real rates narrows.
- U.S. loanable funds: supply shifts right from SLF1 to SLF2. The U.S. real interest rate falls from r1 to r2 (part of the way back), and the quantity of loanable funds rises from Q1 to Q2.
- Japan's loanable funds: supply shifts left, which pushes Japan's real interest rate up.
Connecting policy, interest rates and capital flows
Central banks can change domestic interest rates in the short run, and that changes capital flows. With limited reserves, an open market sale shifts the money supply left and raises the nominal interest rate. With ample reserves, raising interest on reserves does the same. Expected inflation doesn't change right away, so the real interest rate rises too.
- Contractionary monetary policy: higher real interest rate, so financial capital flows in, so demand for the currency rises, so the currency appreciates, so net exports fall.
- Expansionary monetary policy: lower real interest rate, so financial capital flows out, so the currency depreciates, so net exports rise.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Following the capital
The real interest rate in the U.S. rises relative to the real interest rate in Mexico. Explain the effects on (a) financial capital flows between the two countries, (b) the value of the dollar relative to the peso, and (c) the supply of loanable funds in Mexico.
Show the solutionHide the solution
- Step 1: (a) U.S. assets now pay a relatively higher real return, so financial capital flows from Mexico to the U.S.
- Step 2: (b) Mexican investors need dollars to buy U.S. assets, so the demand for dollars rises (and the supply of pesos rises). The dollar appreciates against the peso.
- Step 3: (c) Money leaving Mexico is no longer available to Mexican borrowers, so the supply of loanable funds in Mexico shifts left and Mexico's real interest rate rises.
Answer: (a) Capital flows into the U.S. from Mexico. (b) The dollar appreciates. (c) Mexico's supply of loanable funds decreases.
- Example 2
A long chain from monetary policy
Country K has limited reserves and an inflationary gap, and its central bank sells government bonds. Explain the effects on K's nominal interest rate, its real interest rate in the short run, financial capital flows, the value of K's currency, and K's net exports.
Show the solutionHide the solution
- Step 1: Selling bonds removes reserves, so K's money supply shifts left and the nominal interest rate rises.
- Step 2: Expected inflation doesn't change right away, so K's real interest rate rises too.
- Step 3: K's assets now pay a relatively higher real return, so financial capital flows into K.
- Step 4: Foreign investors need K's currency to buy its assets, so demand for K's currency rises and the currency appreciates.
- Step 5: K's exports become more expensive abroad and imports become cheaper, so K's net exports fall.
Answer: The nominal and real interest rates rise, capital flows in, K's currency appreciates, and K's net exports fall.
- Example 3
Nominal or real? (classic trap)
Country A's bonds pay a nominal interest rate of 8%, and A's expected inflation is 7%. Country B's bonds pay 5%, and B's expected inflation is 1%. Other things equal, toward which country does financial capital flow?
Show the solutionHide the solution
- Step 1: Investors care about real returns. Real rate = nominal rate − expected inflation.
- Step 2: Country A: 8% − 7% = 1%. Country B: 5% − 1% = 4%.
- Step 3: Country B offers the higher real rate, so capital flows toward B, even though A's nominal rate is higher. The trap is comparing nominal rates.
Answer: Toward Country B, whose real interest rate (4%) is higher than A's (1%).
Common mistakes
- Comparing nominal rates instead of real rates. Subtract expected inflation first.
- Saying a capital inflow decreases the supply of loanable funds. Inflows add funds, so the supply of loanable funds shifts right in the country receiving them.
- Getting the currency effect backwards. A capital inflow raises demand for the country's currency, so it appreciates.
On the exam
- Free-response questions often say real interest rates rose in one country, then ask what happens to capital flows, the value of its currency and its net exports. Answer each in order, with a reason.
- You may be asked to show a capital flow on a loanable funds graph. Shift the supply of loanable funds right for the country receiving the funds and left for the country sending them.
Connected topics
Videos
Check yourself
4 questions on 6.6 Real Interest Rates and International Capital Flows. Pick an answer to see if you got it, and why.
U.S. real interest rates fall relative to real interest rates in other countries. Which of the following is most likely?
Country X offers a nominal interest rate of 8 percent with 7 percent inflation. Country Y offers a nominal interest rate of 4 percent with 1 percent inflation. If the two countries' assets are equally risky, where is financial capital most likely to flow, and why?
Which of the following sequences correctly describes a possible effect of a larger government budget deficit in an open economy with a flexible exchange rate?
The U.S. government increases spending and finances it by borrowing, which raises the U.S. real interest rate. What is the most likely effect on the value of the dollar?
0 of 4 answered