Financial capital flows toward the country that pays the higher real interest rate. Those flows shift the supply of loanable funds in both countries, move the demand for or supply of the currency, and change the exchange rate and net exports. Pick a scenario, then switch between step 1 and step 2 to watch the whole chain unfold.
Dashed grey lines show where each market started (5% real interest rate in both countries, 0.90 euros per dollar). Solid lines show where it is now. Step 1 shows the first shock. Step 2 lets financial capital move between the countries.
Savers want the best return. When one country's real interest rate rises relative to another's, financial capital flows into the country with the higher rate. The gap between the two rates is the real interest rate differential.
A capital inflow increases the supply of loanable funds in the country receiving it, which pulls its real interest rate back down. The country the money leaves sees its supply of loanable funds decrease, so its real interest rate rises.
Foreigners need dollars to buy U.S. bonds. A capital inflow increases the demand for dollars, so the dollar appreciates. A capital outflow increases the supply of dollars (or decreases demand), so the dollar depreciates.
When the dollar appreciates, U.S. goods cost more for foreigners and foreign goods cost less for Americans. Exports fall, imports rise, and net exports decrease. A weaker dollar does the reverse.
The current account and the capital and financial account sum to zero. A larger capital inflow (financial account surplus) is matched by a larger current account deficit. That is why a budget deficit can lead to a trade deficit.
Expansionary monetary policy lowers interest rates in the short run. Lower U.S. rates send financial capital abroad, the dollar depreciates, and net exports rise. Contractionary policy does the opposite.
Each row is a chain you can write out on an FRQ. All effects are for the U.S. and the dollar, with Europe as the other country.
| Event | U.S. real interest rate | Capital flow | Market for dollars | Dollar | U.S. net exports |
|---|---|---|---|---|---|
| U.S. government deficit spending increases | ↑ (demand for LF right) | Into the U.S. | Demand right | Appreciates | ↓ |
| U.S. private saving increases | ↓ (supply of LF right) | Out of the U.S. | Supply right | Depreciates | ↑ |
| Expansionary U.S. monetary policy | ↓ (short run) | Out of the U.S. | Supply right | Depreciates | ↑ |
| Contractionary U.S. monetary policy | ↑ (short run) | Into the U.S. | Demand right | Appreciates | ↓ |
| Europe's real interest rate rises | ↑ (outflow cuts U.S. supply of LF) | Out of the U.S. | Supply right | Depreciates | ↑ |
| Europe's real interest rate falls | ↓ (inflow adds to U.S. supply of LF) | Into the U.S. | Demand right | Appreciates | ↓ |
| Capital inflow arrives in the U.S. | ↓ (supply of LF right) | Into the U.S. | Demand right | Appreciates | ↓ |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 6.6. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 6 terminology guide.