Real Interest Rates & International Capital Flows

You’ll be able to

Explain why capital flows respond to real rather than nominal interest rate differentials
Show how capital inflows shift the supply of loanable funds
Explain the trade-off a country accepts when it finances investment with foreign capital

Investors care about real returns

A foreign investor comparing two countries compares real expected returns, because purchasing power is what they will eventually spend. A country with a 10% nominal rate and 8% inflation offers a 2% real return, which is worse than a 4% nominal rate with 1% inflation. So capital chases the higher real rate, and a country can raise nominal rates without attracting capital at all if inflation rises just as much.

The capital flow rule

capital flows toward the higher expected REAL return → inflow shifts loanable funds SUPPLY right → domestic real rate falls

This is the link between Unit 6 and the Unit 4 loanable funds graph.

Foreign capital as a source of loanable funds

A capital inflow adds to the supply of loanable funds, shifting supply right and lowering the domestic real interest rate. That raises investment and can fund growth beyond what domestic saving alone would allow. This is why a country running a current account deficit is not automatically in trouble: if the incoming capital builds factories and infrastructure, the future output can service the obligation. If it funds consumption, it cannot.

The trade-off, stated plainly

Financing investment with foreign capital means future income flows abroad as interest, dividends and profits — which appear later as debits in the current account. It also creates exposure: if foreign investors withdraw, the currency depreciates sharply and interest rates spike, which is the mechanism of a capital-flight crisis. So foreign capital is genuinely useful and genuinely risky, and a good answer names both sides rather than treating it as free money or as a trap.

Worked example

A developing country raises its real interest rate above world levels. Trace the effects on capital flows, the loanable funds market, the exchange rate and net exports.

1.A higher real return attracts foreign capital: an inflow.
2.In the loanable funds market, supply shifts right, which moderates the domestic real rate.
3.To invest, foreigners must buy the domestic currency: demand for it shifts right and it appreciates.
4.A stronger currency makes exports dearer and imports cheaper, so net exports fall.

Answer: Capital flows in, expanding loanable funds supply and appreciating the currency. Net exports fall, so the current account moves toward deficit — the mirror of the financial account surplus the inflow created.

Watch out

A capital inflow shifts the supply of loanable funds right, not demand. Foreigners are supplying funds, not demanding them. Reversing this makes the interest rate move the wrong way.

Checkpoint

International capital flows respond primarily to differences in:

Checkpoint

A large inflow of foreign capital affects the domestic loanable funds market by shifting:

Checkpoint

A country finances substantial domestic investment with foreign capital. A genuine long-run cost is that:

On the exam

When a question gives both a nominal rate and an inflation rate for two countries, compute the real rates before deciding which way capital flows. The nominal comparison is frequently the reverse of the real one, and that is the point of the question.

Answer the 3 checkpoints as you read.