AP Econ Module 41 Capital Flows Balance Payments - Sunny Hills ...

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476 section 8 (a) United States Loanable Funds Markets in Two Countries Quantity of loanable funds Here we show two countries, the Unlted Shtes and Britain, each with its own loanable funds market. The equilibrium in- tersst rate is 6% in the U.S. market but only 2% in the British 0 ouantity of Loanable f markel lhis creates an incentive for capihl b flor/v from Britain to the united States. (b) Brltaln ouantity of loanable funds the equilibrium in the absence of international capital flows is at point Ep.s with an interest rate of 6%. Panel (b) shows the loanable funds market in Britain, where the equilibrium in the absence ofinternational capital flows is at point Es with an interest rate of 2'k. Vill the actual interest rate in the United States remain at 6% and that in Britain at 2%? Not if it is easy for British residents to make loans to Americans. In that case, British lenders, attracted by high American interest rates, will send some of their loanable funds to the United States. This capital inflow will increase the quandty ofloanable funds supplied to American borrowers, pushing the U.S. interest rate down. At the same time, it will reduce the quantity of loanable funds suppJied to British borrowers, pushing the British interest rate up. So international capital flows will narrow the gap between U.S. and British interest rates. Ler's further suppose that British lenders regard a loan to an Americal as being just as good as a loan to one oftheir own compattiots, and American borrowers regard a debt to a British lender as no more cosdy tharr a debt to an American lender. In that case, the flow of funds from Britain to the United Sates will continue until the gap between their interest rates is eliminated. In other words, international capital flows will equalize the interest rates in the two countries. Figure 41.4 shows an international equilibrium in the loanable funds markets where the equilibrium interest rare is 4% in both the United States and Brirain. At this interest rate, the quandry of loanable funds demanded by American borrowers exceeds the quantity of loanable funds supplied by American lenders. This gap is filled by "imported" funds-a capital inflow from Britain. At the same time, the quantity of loanable funds supplied by British lenders is greater than the quantity ofloanable funds demanded by British borrowers. This excess is "exported" in the form ofa capital outflow to the United States, And the two markets are in equilibrium at a common interest rate of4%, At thar interest rate, the total quantity ofloans demaaded by borowers arross the wo markets is equal to the total quantity ofloans supplied by lenders across the rwo markets. In shott, international flows of capital are like international flows of goods and services. Capita-l moves from places where it would be cheap in the absence ofintemadonal capital flows to places where it would be expensive in the absence ofsuch flows. The Open Economy: lnternational Trade and Finance
lnternational Capital Flows (a) United States Brltish lenders lend t0 borrowers in the United States, leading to equalization 0f interest rates at 4% in both countries. At that rate, American borrowing exceeds American lending; the ditference is made up by capihl Capitol outflow fron Bitain lnflows h ihe united States. Meanwhils, British lending exceeds British bonowing; the excess ls a capital outflow from Britain. Underlying Determinants of lnternational Capital Flows The open-economy version ofthe loanable funds model helps us understand international capital flows in terms ofthe supply and demand for funds. But what underlies differences across countries in the supply and demand for funds? And why, in the absence of intemational capital flows, would interest rates differ inrernationally, creating an incenrive for internarional capital flows? International differences in the demand for funds reflect underlfng differences in investment opportunities. In particular, a country with a rapidly growing economy, other things equal, tends ao offer more investment opporrunities than a country with a slowly growing economy. So a rapidly growing economy typically-though not alwayshas a higher demand for capital and offers higher returns to investors than a slowly growing economy in the absence ofcapital flows. As a result, capital tends to flow from slowly growing to rapidly growing economies. The classic example is the flow ofcapital from Britain ro the United States, among other countries, between 1870 and 1914, During that er4 the U.S. economy was growing rapidly as the population increased and spread westward and as the nation indusrria.lized. This created a demand for investment spending on railroads, factories, and so on. Meanwhile, Britain had a much rnore slowly growing population, was already industrialized, and already had a railroad network covering the country. This left Britain with savings to spare, much of which were lent to the United States and other New World economies. International differences in the supply offunds reflect differences in savings across countries. These may be the result of differences in privace savings rates, which vary widely among countries. For example, in 2006, private savings werc 26.5oA ofJapan's GDP but only 14.8% of U.S. GDP. They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall nadonal savings, car lead to capital inflows. (b) Britain m o d u le 41 Capital Flows and the Balance of Paymonts 417
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Page 11 and 12: The Golden Age of Capital Flows Tec

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