The International Capital Market and the Interest Rate

1. The International Capital Market and the Interest Rate The foreign sector influences the domestic interest rate and the quantity of funds available in the domestic economy. The loanable funds approach provides a good framework for analyzing the interaction between U.S. and foreign bond markets. Closed economy An economy in which households, firms, and governments do not borrow or lend internationally. Open economy An economy in which households, firms, and governments borrow and lend internationally. The Loanable Funds Model and the International Capital Market

2. Small Open Economy Small open economy An economy in which total saving is too small to affect the world real interest rate. • The key ideas to remember about a small economy are as follows: • The real interest rate in a small open economy is the same as the interest rate in the international capital market. • If the quantity of loanable funds supplied domestically exceeds the quantity of funds demanded domestically at that interest rate, the country invests some of its loanable funds abroad. • If the quantity of loanable funds demanded domestically exceeds the quantity of funds supplied domestically at that interest rate, the country finances some of its domestic borrowing needs with funds from abroad. The Loanable Funds Model and the International Capital Market

3. Small Open Economy Figure 4.11 Determining the Real Interest Rate in a Small Open Economy The domestic real interest rate in a small open economy is the world real interest rate, (rw), which in this case is 3%.• The Loanable Funds Model and the International Capital Market

4. Large Open Economy Large open economy An economy in which shifts in domestic saving and investment are large enough to affect the world real interest rate. In the case of a large open economy, we cannot assume that the domestic real interest rate is equal to the world real interest rate. The Loanable Funds Model and the International Capital Market

5. Determining the Real Interest Rate in a Large Open Economy Figure 4.12 Saving and investment shifts in a large open economy can affect the world real interest rate. The world real interest rate adjusts to equalize desired international borrowing and desired international lending. At a world real interest rate of 4%, desired international lending by the domestic economy equals desired international borrowing by the rest of the world.• The Loanable Funds Model and the International Capital Market

6. Making the Connection Did a Global “Saving Glut” Cause the U.S. Housing Boom? Some economists have argued that the Fed persisted in a low-interest-rate policy for too long a period, thereby fueling the housing boom. Fed Chairman Ben Bernanke disagreed, arguing that “a significant increase in the global supply of saving—a global saving glut— . . . helps to explain . . . the relatively low level of long-term interest rates in the world today.” The Loanable Funds Model and the International Capital Market