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Interest rate changes in one country and currency values, the balance of payments, and exports.

Changes in interest rates in one country impact economic conditions in other countries. In this video, walk through a chain of events that starts with a change in interest rates in the United States that affects the relative value of the dollar, the Japanese Yen, and exports.

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Video transcript

- [Instructor] What we're gonna do in this video is try to think of the chain of events that would happen if the supply of loanable funds were to increase in the United States. And the way that that could happen is let's say the Federal Reserve were to so to speak print money, and then use that money to buy treasuries in the US. So it's inserting those Federal Reserve notes into the quantity of loanable funds. Well what would happen is that the supply of loanable funds would shift to the right. So our new supply would look like this, would look like this. I'll call that S prime. And then we'd have a new equilibrium price of those funds, which we would call our real interest rate. So then we get to r prime. So our real interest rates have gone down, and we have a higher quantity of money that is being loaned, Q prime. But what would be the effect of that? What would be the effect of that relative to other countries? And I'm just picking Japan here as another country, but this could be the case with many other countries where they have relatively free flows of goods and financial capital. And to help us think through that, I drew the balance of payments for each country. And the balance of payments is made up of the current account, which is talking about the flows of goods and services, and then you have what's sometimes called a capital account, sometimes the capital and financial account, which is talking about the flow of, it oftentimes, you could think of it as financial investment or investments of some kind or the flow of funds. So pause this video and think about what would happen. Well, if the real interest rate go down in the United States and we're assuming that all else equal in every other country, well then you have a situation where in Japan, the relative real interest rates are now higher, so relative, relative real interest rates, interest rates, are higher. Now in general, people might want to say hey, if I can get a higher or a higher than before relative real interest rate, it might not be absolutely higher, but it's higher than it was before relative to the United States, well that might increase the financial flows from the United States to Japan. And so you might have some more people, not everyone, but some more people than before, who want to take their dollars, convert it into yen, and buy financial assets in Japan where they can get that relatively now higher real interest rate. Well if these folks are converting from dollars to yen, what's the immediate effect of that? Well, it will increase demand for the yen and so the price of the yen in dollar terms will go up. Or another way to think about it is this is going to cause the dollar to depreciate, depreciate, relative, relative to the yen. So we're just gonna put that aside right over here, 'cause this is gonna have other implications. But that dollar, it's used to buy yen, and then those investors will maybe buy Japanese bonds. And so what's happening? Well we're talking about the transfer of financial assets. And so in the United States, the capital and financial account, that will go down. This will go down. You could think of it as being debited. And in Japan, they're getting, they're getting an increase in financial assets. People are investing more in Japanese bonds. However you want to think about it. And so that increase in funds, that goes up, and so this is getting credited. Now, in other videos, we've talked about how over time, the balance of payments tend to balance out. If one side is getting debited, the other side is getting credited, or vice versa. So how is that going to work out in this situation? Well that all goes back to the fact that the dollar has depreciated relative to the yen. If the dollar depreciates relative to the yen, what is that going to do? Well now American goods, American goods, are relatively cheaper, relatively cheaper, or cheaper than they were before, cheaper in Japan. That's hard to read. And Japanese goods more expensive, more expensive, in the US. And so what is going to happen? Well in that situation, that means that the US is going to export more to Japan. Their goods are now relative, are now cheaper in Japan, Japanese goods are now more expensive in the US. So they're going to buy fewer Japanese, Japanese goods and sell, and export, export more American goods, American goods. And so what's going to happen on our current account? Well if your exporting more, that means your current account goes up. It is going to be credited. It is going to be credited. And then the opposite's going to happen to Japan. Relative to the US, it's going to export less and import more. So its current account is going to be, is going to be debited. Now economies are complex things, and what I've just done is a little bit of a simplification. But these are the general trends that you would expect. Other things that you might expect is well, if you have this flow of financial capital into Japan, well that might increase their loanable funds. And so their real interest rate might eventually go down and all of these cycles would keep going and reverberating back and forth over time. But this is the general chain of events that you might expect, that the interest rates in Japan will become relatively higher. And so you have a flow of financial funds going from the US to Japan. In the process, when they convert from dollar to yen, the dollar is going to get cheaper, the yen's going to get more expensive. The American capital and financial account goes down 'cause you have this net outflow of financial funds. But because of the depreciation of the dollar, the US is now importing less and exporting more. Now a question is is this good or bad for either country? Well, it depends what the country's goals are. This might be good for the US if their goal was to export more American goods. Or it might be bad for the US if they said hey, now Japanese goods are more expensive, and maybe they're dependent on some type of Japanese goods in some way, shape, or form. That might not be the case with the US, but in another country, let's say they're dependent on oil from other countries or they're dependent on military hardware from other countries. And if those things become more expensive, or food, that might make it a lot harder for their citizens. So it's an interesting thing to think about, whether this is good or bad and how all of these things fit together.