Answer to Question #150319 in Macroeconomics for Kane

Question

Real interest rates in France rise faster than interest rates in the U.S.
What happens to capital flows in this scenario, eventually, due to the change in value of its currency?
Graphically illustrate the change in the loanable funds market for the U.S. given the information gathered in question A. Be sure to label your graph.
What impact did this have on domestic real interest rate?

Answer 1

$$Solution$$

Since the higher interest rates in France lenders the economy a higher return relative to the US. This higher interest rates will attract foreign capital from the US thus causing the exchange rate to rise, due to this effect the capital inflows will also rise i.e to France with a relatively higher real interest rates.

With an increase in interest rate there is a high demand for loanable funds, and this will reduce the supply of the loanable funds in France, and sine US is the vice versa, there will be a low demand for the loanable funds which in turn will increase the supply of the US dollars.

These scenarios will cause a domestic boom.

 If the demand for capital increases to D2 in Panel (b), the demand for loanable funds is likely to increase as well. Panel (a) shows the result in the loanable funds market—a shift in the demand curve for loanable funds from D1 to D2 and an increase in the interest rate from r1 to r2. At r2, the quantity of capital demanded will be K2, as shown in Panel (b).

This can be illustrated graphically as below;