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Exchange Rates, Trade & Capital Flows

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Interest rates drive capital flows

Capital flows — the movement of financial investment across borders — respond strongly to relative real interest rates. Investors seek the highest return, so when a country’s interest rates rise relative to others, financial capital flows in: foreigners buy its assets, which requires buying its currency. This raises demand for the currency and causes it to appreciate. Conversely, falling relative rates send capital out and the currency depreciates. This interest-rate → capital-flow → exchange-rate channel is how the financial sector connects to the open economy.

Policy spills over to the exchange rate

Monetary and fiscal policy affect exchange rates through interest rates. Contractionary monetary policy raises interest rates → attracts capital inflows → currency appreciates → net exports fall (a partial offset to the policy). Expansionary monetary policy lowers rates → capital outflow → currency depreciates → net exports rise (reinforcing the stimulus). Expansionary fiscal policy that raises interest rates (via crowding out and greater borrowing) can likewise cause an appreciation that reduces net exports — a further leakage that dampens the fiscal stimulus.

Exchange rates and aggregate demand

Because net exports (Xn) are a component of aggregate demand, exchange rate changes shift AD. A depreciation makes exports cheaper and imports pricier, raising net exports and shifting AD right (expansionary). An appreciation does the reverse, lowering net exports and shifting AD left (contractionary). This creates feedback loops: for example, expansionary monetary policy lowers rates, depreciates the currency, and raises net exports — both the domestic investment channel and the net-export channel push AD in the same direction.

The interest rate → exchange rate → net exports chain
Domestic real interest rate ↑ → capital inflow → currency appreciates → net exports ↓ → AD ↓
Reverse every arrow when the domestic interest rate falls: capital outflow, depreciation, higher net exports, AD up.
Worked example

A central bank pursues expansionary monetary policy, lowering domestic interest rates. Trace the effect through capital flows, the exchange rate, net exports, and aggregate demand.

  1. 1.Lower domestic interest rates make domestic assets less attractive relative to foreign ones, so financial capital flows out.
  2. 2.Capital outflow means residents supply more domestic currency to buy foreign assets, so the currency depreciates.
  3. 3.A weaker currency makes exports cheaper abroad and imports more expensive, so net exports rise.
  4. 4.Higher net exports (plus the higher domestic investment from lower rates) shift AD to the right, raising real GDP.
Answer: Lower interest rates cause capital outflow and currency depreciation, which raises net exports; combined with stronger domestic investment, AD shifts right. The net-export channel reinforces expansionary monetary policy.
Checkpoint

A country’s central bank raises its real interest rate well above rates in other countries. What is the most likely sequence of effects?

Watch out

Capital flows follow relative interest rates, not the level alone. A rate rise attracts capital only if it rises relative to other countries. And remember an appreciation reduces net exports — a stronger currency is not automatically "good" for the trade balance.

Checkpoint

A nation’s currency depreciates sharply against its trading partners. Holding all else constant, what is the effect on that nation’s net exports and aggregate demand?

On the exam

Free-response questions increasingly chain the three markets: money market → interest rate → forex → net exports → AD. Practice tracing a single policy all the way through, keeping every arrow’s direction consistent — that full linkage is where the points are.

Answer the 2 checkpoints as you read.

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