6.6 Real Interest Rates and International Capital Flows

Explain (using graphs as appropriate) how differences in real interest rates across countries affect financial capital flows, foreign exchange markets, and loanable funds markets.

• In an open economy, differences in real interest rates across countries change the relative values of domestic and foreign assets. Financial capital will flow toward the country with the relatively higher interest rate. [See EK MKT-4.E.2 and EK MEA-4.A.6 for explanations of the impact on the loanable funds market and on net exports.]
• Central banks can influence the domestic interest rate in the short run, which in turn will affect net capital inflows.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.