5.8

Real Interest Rates and International Capital Flows

AP Macroeconomics

Real vs. nominal interest rates review

How capital flows work

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Capital flows and the loanable funds market

Capital inflows increase the supply of loanable funds

246810121234567Quantity of Loanable FundsReal Interest Rate (%)Closed economyWith capital inflowSLF (domestic)SLF (domestic + foreign)DLF

Capital inflows increase supply of loanable funds → lower r → more investment

Capital outflows decrease the supply of loanable funds

The link: fiscal policy → interest rates → capital flows

Expansionary fiscal policy chain

Effect on the exchange rate

Effect on net exports

Complete chain: fiscal policy to net exports

Monetary policy and capital flows

Contractionary monetary policy

Expansionary monetary policy

The twin deficits hypothesis

Summary: policy → rates → flows → exchange rate → trade

AP Exam Tips

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Common Mistakes

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