Short on time? This page is the recap. For explanations, the three-panel graph and worked examples, use the full study guide.
Recap
- Financial capital is money used to buy financial assets (bonds, shares, deposits). It moves between countries in search of the best real return.
- Real interest rate = nominal interest rate − expected inflation.
- Funds flow towards the country whose real interest rate is relatively higher.
- The receiving country’s currency is in higher demand, so it appreciates; its net exports fall.
- The inflow raises the supply of loanable funds at home; the outflow lowers it in the other country. The two real rates move closer together.
- A central bank can change the domestic interest rate in the short run, and so change net capital inflows.
Key relationships
| Change in Valdoria (Kestria unchanged) | Capital flow | Valda | Valdoria’s NX | Flow’s effect on Valdoria’s loanable funds | Kestria’s real rate |
|---|---|---|---|---|---|
| Real rate rises (contractionary policy, more government borrowing, more investment demand) | inflow rises | appreciates | fall | supply rises | rises |
| Real rate falls (expansionary policy, more saving) | inflow falls | depreciates | rise | supply falls | falls |
Valdoria (valda, VD) and Kestria (kesta, KS) are the fictional countries used in the study guide.
Balance of payments: CA + CFA = 0. A larger capital and financial account surplus (net inflow) goes with a larger current account deficit.
Assumptions
- Flexible exchange rates set in the foreign exchange market.
- Other things equal: investors respond to real interest rates only (risk and expected currency changes are ignored).
- You predict directions, not sizes.
Mistakes to avoid
- Comparing nominal rates. Subtract expected inflation first.
- Inflow → depreciation. It is an appreciation.
- Shifting loanable funds demand for a capital flow. Capital flows shift supply.
- Ignoring the other country. Its real rate moves the opposite way to the flow.
- “Tight money raises net exports.” It lowers them.
- Same signs for CA and CFA. They have opposite signs.
Quick self-check
- Valdoria: nominal rate 6%, expected inflation 2.5%. Kestria: nominal 4%, expected inflation 0.5%. Which way does capital flow? (Neither, other things equal: both real rates are 3.5%)
- Valdoria’s real rate rises above Kestria’s. What happens to the kesta? (It depreciates)
- Valdoria’s CFA is +VD 12 billion. What is its CA? (−VD 12 billion)
- Kestria’s central bank lowers its interest rate. What happens to Valdoria’s net capital inflow? (It rises)
Next: practice questions.