Graph walkthrough · Macro · Loanable funds market
Foreign capital flows in
Foreign savers start buying this country's bonds and lending to its firms.
Step 1 of 4 · Before the inflow
The horizontal axis is the quantity of loanable funds. The vertical axis is the real interest rate. The market is at E₀.
The chain in words
Step 1
Before the inflow
The horizontal axis is the quantity of loanable funds. The vertical axis is the real interest rate. The market is at E₀.
Step 2
Supply of funds shifts right
Foreign saving adds to the pool of funds available at every interest rate, so the supply of loanable funds shifts right. At the old rate, lenders offer more than borrowers want.
Step 3
The real interest rate falls
The real interest rate falls. Cheaper borrowing makes more projects pay, a movement along demand. The market settles at E₁: a lower rate and more investment, some of it funded from abroad.
Step 4
The mirror image
The inflow also has a mirror image. Foreigners must buy this country's currency to lend here, so the currency tends to appreciate, and the country runs a trade deficit that matches the capital inflow.
Takeaway. A capital inflow shifts the supply of loanable funds right, lowering the real interest rate and raising investment.
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Lesson: Balance of Payments