Real Interest Rates and International Capital Flows: Study Guide (Macroeconomics 6.6)

Why financial capital moves between countries

Savers and investors can buy bonds, shares and bank deposits in other countries. Funds used to buy these assets are called financial capital. When funds cross a border to buy assets, that is an international capital flow.

Where will the funds go? Other things equal, to where they earn the best real return. Recall from Topic 4.2:

Real interest rate = nominal interest rate − expected inflation

If one country’s real interest rate rises compared with another’s, its assets become relatively more attractive. Financial capital flows towards the country with the relatively higher real interest rate. Key terms:

• Capital inflow: foreigners buy more of the country’s assets (money flows in).
• Capital outflow: residents buy more foreign assets (money flows out).
• Net capital inflow: inflows minus outflows. In the balance of payments it shows up in the capital and financial account (CFA).

Our fictional economies: Valdoria and Kestria

As in Topic 6.5, Valdoria is a fictional country whose currency is the valda (VD), and Kestria is a fictional country whose currency is the kesta (KS). Exchange rates are written as kestas per valda. All interest rates and figures are fictional.

The chain across three markets

Suppose Valdoria’s real interest rate rises above Kestria’s. Follow the effects market by market.

1. Capital flows. Kestrian savers buy more Valdorian bonds, and Valdorian savers buy fewer Kestrian bonds. Net capital inflow into Valdoria rises.
2. Foreign exchange market. To buy Valdorian assets, Kestrians need valdas, so the demand for valdas rises. (Valdorians buying fewer Kestrian assets also supply fewer valdas.) The valda appreciates; the kesta depreciates.
3. Net exports (Topic 6.5). The stronger valda makes Valdorian goods dearer abroad and Kestrian goods cheaper in Valdoria. Valdoria’s net exports fall; Kestria’s rise.
4. Loanable funds in Valdoria. The inflow is extra saving lent in Valdoria, so the supply of loanable funds shifts right. This pulls Valdoria’s real interest rate back down a little.
5. Loanable funds in Kestria. Funds leaving Kestria reduce the supply of loanable funds there, so it shifts left and Kestria’s real interest rate rises.
6. Balance of payments. The inflow is a credit in Valdoria’s CFA. Because the current account (CA) and CFA sum to zero, a bigger CFA surplus goes with a bigger CA deficit, and that matches the fall in net exports in step 3.

Steps 4 and 5 move the two real interest rates closer together. That is why, other things equal, the flow does not go on growing for ever.

Worked example 1: compare real, not nominal, rates

Question. Valdorian bonds pay a nominal interest rate of 7% and expected inflation in Valdoria is 3%. Kestrian bonds pay 9% and expected inflation in Kestria is 7%. (a) Calculate each country’s real interest rate. (b) In which direction will financial capital flow? (c) State the effect on the value of the valda and on Valdoria’s net exports.

(a) Valdoria: 7% − 3% = 4%. Kestria: 9% − 7% = 2%.

(b) Financial capital flows from Kestria to Valdoria, even though Kestria’s nominal rate is higher. For every 100 units of purchasing power lent for a year, a saver gains about 4 units in Valdoria but only about 2 in Kestria.

(c) Kestrians demand more valdas to buy Valdorian bonds, so the valda appreciates. Valdorian goods become dearer abroad and Kestrian goods cheaper in Valdoria, so Valdoria’s net exports fall.

Check. If you compared nominal rates you would predict the opposite flow. Always subtract expected inflation first.

What changes real interest rates

A difference in real interest rates can open up for several reasons. Topic 6.4 traced the policy cases to the exchange rate; here the focus is the real interest rate, the loanable funds markets in both countries and the balance of payments.

• Monetary policy (short run). A central bank can move the domestic interest rate in the short run (Topic 4.6). If expected inflation does not change at once, the real rate moves with the nominal rate. Contractionary policy raises the rate, so net capital inflows rise and the currency appreciates. Expansionary policy lowers the rate, so net capital inflows fall and the currency depreciates.
• Government borrowing. A larger budget deficit financed by borrowing raises the demand for loanable funds, so the real interest rate rises (Topics 4.7 and 5.5). Inflows rise, the currency appreciates and net exports fall. This is one more way a deficit can crowd out private spending.
• Saving and investment behaviour. If households save more, the supply of loanable funds rises and the real rate falls, so net capital inflows fall. If firms want to invest more, perhaps because of an investment tax credit, the demand for loanable funds rises and the real rate rises, so inflows rise.

Worked example 2: a central bank raises its interest rate

Question. Valdoria’s central bank uses contractionary monetary policy. The nominal interest rate rises from 3% to 5% while expected inflation stays at 2%. Kestria’s real interest rate stays at 2%. Before the change, Valdoria’s capital and financial account balance was −VD 5 billion. (a) Find Valdoria’s real interest rate before and after. (b) Explain the effect on capital flows and on the valda. (c) After the change the CFA balance is +VD 7 billion. Assuming CA + CFA = 0, find the current account balance before and after. (d) Explain how the exchange-rate effect adds to the effect of the policy on aggregate demand.

(a) Before: 3% − 2% = 1%. After: 5% − 2% = 3%.

(b) Before the change Valdoria’s real rate (1%) was below Kestria’s (2%), so funds tended to flow out, consistent with the net outflow shown in the CFA. After it, Valdoria’s real rate (3%) is above Kestria’s (2%), so net capital inflow rises. Kestrians demand more valdas, so the valda appreciates.

(c) CA = −CFA. Before: CA = +VD 5 billion. After: CA = −VD 7 billion. The current account balance falls by VD 12 billion.

(d) The higher interest rate already lowers investment, which shifts AD left. The appreciation also lowers net exports (Topic 6.5), so AD shifts further left. In an open economy with a flexible exchange rate, the two effects work in the same direction.

Check. The CFA moves from outflow (−5) to inflow (+7), and the CA moves from surplus (+5) to deficit (−7). The signs are always opposite, so CA + CFA = 0 holds both times.

Writing the chain in an exam answer

Free-response questions on this topic usually ask you to link two or three graphs. Each link needs a reason, not just an arrow. Here is a model chain for a case that starts with private firms rather than policy: Valdorian firms become more optimistic and want to borrow more for new factories, while nothing changes at first in Kestria.

1. Firms’ extra borrowing raises the demand for loanable funds in Valdoria, so Valdoria’s real interest rate rises.
2. Valdorian assets now pay a relatively higher real return, so Kestrian savers buy more of them and Valdorian savers buy fewer Kestrian assets. Net capital inflow rises.
3. Kestrians demand more valdas to buy Valdorian assets, so the valda appreciates.
4. The inflow also raises the supply of loanable funds in Valdoria, so the real interest rate rises by less than it would in a closed economy. In Kestria the supply of loanable funds falls and the real rate rises.
5. The stronger valda makes Valdorian goods dearer abroad and Kestrian goods cheaper at home, so net exports fall. This offsets part of the boost to AD from the extra investment.

When you draw the graphs, label the axes exactly: “Real interest rate” and “Quantity of loanable funds” for the loanable funds market; “Exchange rate” (with the units, such as KS per VD, or “price of valdas in kestas”) and “Quantity of valdas” for the foreign exchange market. Show the shifted curve, the old and new equilibria and the direction of the change on the vertical axis.

How far the course takes this

• Flexible exchange rates. The course treats the exchange rate as set by supply and demand in the foreign exchange market.
• Directions, not sizes. You predict which way capital flows, exchange rates, real interest rates and net exports move.
• Short run. The central bank’s influence on the interest rate is a short-run effect.
• Background only. Real investors also weigh risk and the chance that the currency will change in value. You do not need these for the course; answer as if real interest rates alone decide.

Common misconceptions

• Comparing nominal rates. Capital follows the higher real rate. Subtract expected inflation first.
• “A capital inflow makes the currency depreciate.” Foreigners need the home currency to buy home assets, so demand for it rises and it appreciates.
• Shifting the wrong loanable funds curve. An inflow adds to the supply of loanable funds in the receiving country; an outflow reduces supply in the sending country. Government borrowing and investment shift demand.
• Forgetting the other country. If Valdoria gains an inflow, Kestria has an outflow, a lower supply of loanable funds and a higher real rate.
• “Tight money raises net exports.” Contractionary policy raises the real rate, causes an appreciation and lowers net exports.
• Mixing up the accounts. Capital flows are recorded in the CFA. A CFA surplus goes with a CA deficit, not a CA surplus.
• Confusing financial and physical capital. Buying a foreign bond is a financial capital flow, not a purchase of machines.

Where this leads

This is the last topic in the course framework. It links Units 4 and 6: the loanable funds market (Topic 4.7), monetary policy (Topic 4.6) and the foreign exchange market all meet here, and the result feeds into net exports through the chain in Topic 6.5. Try the practice questions now, then use the revision notes and the checklist. For an exam-style review, return to the course roadmap and revisit any unit that still feels weak.