Topic 6.6 Notes – Real Interest Rates and International Capital Flows

Real Interest Rates and Why Capital Moves

The real interest rate tells investors how much their purchasing power actually increases.

$$\text{Real interest rate} = \text{Nominal interest rate} - \text{Expected inflation}$$

If a bond pays 8% and expected inflation is 3%, the real return is 5%.

In an open economy, investors can buy foreign stocks, bonds, and bank deposits. So they compare real returns across countries. A country with the higher real interest rate offers more purchasing power growth.

Core rule

• Higher domestic real interest rate (relative to abroad) → capital inflow
• Lower domestic real interest rate → capital outflow

It’s always relative. If U.S. rates are 4% and Europe’s are 6%, money tends to flow to Europe.

Inbound vs Outbound Capital Flows

Capital flow simply means the movement of financial investment funds across borders.

Inbound capital flow

Foreign investors buy domestic assets (stocks, bonds, bank accounts).

• Happens when domestic real interest rate rises relative to other countries
• Example: Japanese investors buying U.S. Treasury bonds because U.S. rates are higher
• Creates net capital inflow
• Increases demand for the domestic currency (foreigners need it to buy assets)

Outbound capital flow

Domestic investors buy foreign assets.

• Happens when domestic real interest rate falls relative to abroad
• Example: Americans buying German bonds because European rates are higher
• Creates net capital outflow
• Increases supply of domestic currency in foreign exchange markets

Here’s a clean comparison:

Now let’s connect this to the three markets you draw on tests.

Loanable Funds Market

The loanable funds market determines the real interest rate through saving (supply) and borrowing (demand).

This graph shows the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. The upward-sloping curve is the supply of loanable funds, and the downward-sloping curve is the demand. Their intersection determines the equilibrium real interest rate.

Loanable funds market equilibrium

Foreign investors are part of the supply of loanable funds.

If the domestic real interest rate rises relative to other countries:

• Capital inflow increases
• Supply of loanable funds shifts right
• This puts downward pressure on the interest rate

That rightward shift reflects foreign money entering the domestic financial system.

If domestic rates fall:

• Capital outflow
• Supply shifts left

On an FRQ, if they say “foreign investors purchase domestic bonds,” that means S shifts right in loanable funds.

Foreign Exchange Market

The foreign exchange market determines the value of a currency.

In the graph below, the vertical axis shows the price of dollars in pesos, and the horizontal axis shows the quantity of dollars. The intersection of supply and demand gives the equilibrium exchange rate and quantity exchanged.

Foreign exchange market equilibrium

• Demand for domestic currency comes from:
  • Foreigners buying exports
  • Foreigners buying domestic assets
• Supply of domestic currency comes from:
  • Domestic consumers buying imports
  • Domestic investors buying foreign assets

If domestic real interest rate rises:

• Capital inflow increases
• Demand for domestic currency shifts right
• Currency appreciates

If domestic rates fall:

• Capital outflow
• Supply shifts right
• Currency depreciates

This is a favorite exam chain: higher interest rate → appreciation.

Net Exports Connection

Exchange rates affect trade.

• Appreciation → exports more expensive, imports cheaper → net exports fall
• Depreciation → exports cheaper, imports more expensive → net exports rise

Full chain you should memorize:

1. Real interest rate increases (relative to abroad)
2. Capital inflow
3. Demand for currency increases
4. Currency appreciates
5. Net exports decrease

Reverse every step if the interest rate falls.

Central Banks and Capital Flows

Central banks influence short-run interest rates.

Contractionary monetary policy

Decrease money supply → interest rate rises.

• Attracts foreign capital
• Currency appreciates
• Net exports decrease

Example: In the early 1980s, Federal Reserve Chair Paul Volcker sharply raised U.S. interest rates to fight inflation. High U.S. rates attracted global capital and strengthened the dollar.

Expansionary monetary policy

Increase money supply → interest rate falls.

• Capital outflow
• Currency depreciates
• Net exports increase

After the 2008 financial crisis, the Federal Reserve lowered interest rates significantly. Lower returns reduced capital inflow pressure and contributed to a weaker dollar relative to high-rate countries.

On questions, when they say “the central bank lowers rates,” you should automatically think: capital outflow → depreciation → NX rises.