Real Interest Rates and International Capital Flows
| English | Chinese | Pinyin |
|---|---|---|
| real interest rates | 实际利率 | shí jì lì lǜ |
| capital inflow | 资本流入 | zī běn liú rù |
| capital flows | 资本流动 | zī běn liú dòng |
Money chases the best return
- Savers everywhere want the highest return they can get.
- So real interest rates 实际利率 drive money between countries.
- Raise your real rate above the world's, and foreign money flows in.
- This is the last link that ties the whole open economy together.
International capital flows are driven mainly by differences in:
Money moves toward the highest real return.
Foreign savers sending money into a high-rate country create a capital ______.
A capital inflow is money entering to earn the higher rate.
A capital inflow appreciates the currency because foreigners:
Buying the currency to invest raises demand, so it appreciates.
Capital inflows raise the currency
- When a country's real interest rate rises above the rest of the world's, foreign savers send money in — a capital inflow 资本流入.
- To invest, those foreigners must first buy the country's currency.
- So the inflow raises demand for the currency, and it appreciates.
- High real rates therefore mean a strong currency.
A financial account surplus (capital inflow) is matched by a current account:
The appreciation makes exports dearer and imports cheaper, pushing the current account to deficit.
How the two accounts tie together
- These capital flows 资本流动 link the two balance-of-payments accounts.
- A financial account surplus (money flowing in to buy assets) matches a current account deficit.
- Why? The stronger currency the inflow creates makes exports dearer and imports cheaper.
- That pushes the trade balance the other way — into deficit — exactly offsetting the inflow.
A country raises its real interest rate from 2% to 5%. By how many percentage points did it rise?
5 − 2 = 3 percentage points, far above the world rate — drawing capital in.
Order the chain from a higher real rate to a current-account deficit.
Higher rate → inflow → appreciation → trade gap widens.
Worked example
- Worked idea. A country lifts its real interest rate from 2% to 5%, far above the world's.
- Foreign investors pour money in to buy its bonds — a capital inflow — buying its currency first, so it appreciates.
- The stronger currency then makes exports dearer, so the current account moves toward deficit.
- Higher real rates draw in capital but widen the trade gap — the two accounts offset.
Capital inflow or outflow?
Money chases the best real return. Sort each case by which way capital flows.
Real interest rates drive capital flows. A rate above the world's brings a capital inflow: foreigners buy the currency, which appreciates. The stronger currency makes exports dearer and imports cheaper, moving the current account toward deficit — so a financial account surplus offsets a current account deficit ($2\% \to 5\%$ draws capital in but widens the trade gap).