Suppose that real interest rates increase acrossEurope. Explain how this development affects U.S. net capital outflow. Then explain how it affects U.S. net exports by using a formula from the chapter and by drawing a diagram. What happens to the U.S. real interest rate and real exchange rate?
Answer:
When real interest rates rise in Europe, European assets become more attractive relative to U.S. assets. U.S. residents increase their purchases of European (foreign) assets and foreign residents reduce purchases of U.S. assets. Net capital outflow (NCO), defined as purchases of foreign assets by U.S. residents minus purchases of U.S. assets by foreigners, therefore increases (NCO rises).
Use the identities from the chapter:
NCO = NX (net capital outflow equals net exports)
NX = S − I (net exports equal national saving minus domestic investment)
Because NCO increases, and NCO = NX, U.S. net exports rise. Intuitively, the rise in purchases of foreign assets by U.S. residents means more dollars are supplied in the foreign-currency exchange market to buy foreign currency; that increased supply of dollars causes the U.S. real exchange rate to depreciate (the real value of the dollar falls). The depreciation makes U.S. goods cheaper to foreigners and foreign goods more expensive to U.S. residents, so net exports increase.
What happens to the U.S. real interest rate? In an integrated world capital market, the U.S. real interest rate moves toward the new (higher) foreign rate. If world (or European) rates increase and financial markets are open, the U.S. real interest rate tends to rise as well (in a small open-economy model the domestic real interest rate equals the world real interest rate, so it increases to the new higher level). The rise in the global real rate also tends to reduce U.S. investment (I), raising S − I and reinforcing the increase in NCO.
Diagram (market for foreign-currency exchange):
Step illustrated by diagram: supply of dollars shifts right (S → S’) because U.S. residents buy more foreign assets when European rates rise.
Result: the equilibrium real exchange rate ε falls (depreciation of the dollar), and the quantity of net exports (NX) increases.
Summary:
U.S. net capital outflow (NCO) increases when European real rates rise.
Because NX = NCO (and NX = S − I), U.S. net exports increase.
The U.S. real exchange rate depreciates (ε falls) as the supply of dollars in the foreign-exchange market increases.
The U.S. real interest rate tends to rise toward the higher foreign (European) rate in integrated global capital markets.
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