International Capital Flows

The basic saving-investment model can be extended to include international capital flows, purchases or sales of real and financial assets across international borders. International capital flows allow countries whose productive investment opportunities are greater than domestic savings to fill in the gap by borrowing from abroad. In addition, they allow countries to run trade imbalances – situations in which the country's exports of goods and services do not equal its imports of goods and services. Changes in risk, foreign interest rates, and economic policies that affect investment or national saving can affect a country's capital inflows, real interest rate, and level of investment in capital.

Exploration: How do changes in saving and investment affect interest rates and capital flows in the open economy?

The applet above illustrates the supply of and demand for savings in the economy, where the supply of savings is augmented by capital inflows (KI), or saving from other countries. In an open (international) economy, the long-run equilibrium interest rate and level of investment are determined by the intersection of the S+KI and I curves. To use the graph, use the mouse to drag the I or S+KI labels to the right or left and click on the New Equilibrium button to observe the movement to the new equilibrium. Click the Update button to refresh the curves to their current positions and click the Reset button to restore the curves to their original positions.

1. What is the effect of an increase in the federal government's budget deficit on domestic real interest rates, the capital inflow, and the trade deficit? What do you conclude about the relationship between a country's level of national saving and its trade deficit?
   
   
2. During the 1990s the U.S. federal budget deficit shrank, eventually turning into a budget surplus by the late 1990s. Yet, during this time the trade deficit continued to grow. According to the model, what else must have been occurring that led to the increased trade deficits?
   
   
3. What are the economic effects of an increase in the perceived risk of owning a country's assets?
   
   
4. What are the economic effects of an increase in technology that improves the productivity of capital in a country?

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