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AP®︎/College Macroeconomics
Course: AP®︎/College Macroeconomics > Unit 6
Lesson 6: Real Interest Rates and International Capital FlowsInterest 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.
Want to join the conversation?
- Last video! Thank you so much Sal :)(6 votes)
- hi.
what happened in 2008 quantitative easing (QE1) was the opposite. dollar appreciated. can you tell me why that happened?(1 vote) - Since the interest rate in the U.S. is now relatively cheaper than the interest rate in Japan, does anyone from Japan take out a loan in the U.S.? If so, how would that affect the chain of events in this video? Thanks!(1 vote)
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.