Question

Consider what happens if there is an influx of funds from foreign savers into the nation of Cashstrapped.

i. What happens to Cashstrapped’s net capital inflow (NCI)?  

ii. Using a well-labeled loanable funds market graph, illustrate what happens when the foreign funds flow in.  

Assume loanable funds continue to flow into Cashstrapped from abroad.

i. What does this inflow imply about the real interest rate abroad versus in Cashstrapped?

ii. What will be the effect of a continued capital inflow on Cashstrapped’s current account?

iii. Given the inflow, is Cashstrapped’s currency likely to appreciate or depreciate relative to other currencies. Explain your answer.  

Answer 1

i. Since the foreign savers are investing their funds into the nation of cashstrapped, the net capital inflow will increase. Net capital inflow is the total foreign capital coming in the nation of cashstrapped- capital invested by the nation of cashstrapped in foreign country. Since the capital is coming in the nation of cashstrapped, net capital inflow will increase.

ii. When the foreign funds flow in, supply of loanable funds increases and the interest rate in the domestic economy decreases

i. If the loanable funds continue to flow into cashstrapped from abroad, it implies that the real interest in cashtrapped is higher than that in abroad. Since foreign savers get a greater return on their funds from cashstrapped than abroad, they keep investing in cashstrapped.

ii. Continued capital inflow will worsen the current account of cashstrapped and the economy will suffer from current account deficit. Money is coming in through capital inflow and capital accouny is improving, to maintain balance of payments money will move out through import of goods and current account will worsen