Savers can lend across borders. That links the The Loanable Funds Market market with the foreign exchange market.
Key idea
A higher real interest rate in a country draws in foreign financial capital. To buy that country's assets, foreign savers must first buy its currency, so demand for the currency rises and it appreciates. The inflow also adds to the supply of loanable funds there. A lower real rate sends capital out and the currency depreciates.
Why it works
Savers look for the best return for the risk. If U.S. bonds pay a higher real rate than similar European bonds, European savers want U.S. bonds, and they need dollars to buy them. That raises demand for dollars. The classic chain for a U.S. budget deficit: the government borrows more → the real interest rate rises → foreign capital flows in → the dollar appreciates → U.S. exports get dearer and imports cheaper → net exports fall. In the loanable funds market, the same inflow adds to supply, which keeps the rate from rising as much as it otherwise would.
Worked examples
Worked example: The deficit chain
The U.S. budget deficit grows. Trace the effects through to net exports.
- More government borrowing: demand for loanable funds rises, so the real interest rate rises.
- Higher returns draw foreign capital: demand for dollars rises, and the dollar appreciates.
- A stronger dollar makes exports dearer and imports cheaper: net exports fall.
Answer: r ↑ → capital inflow → dollar ↑ → NX ↓
Worked example: An inflow in numbers
Supply of loanable funds: $r = 2 + 0.01Q$; demand: $r = 8 - 0.01Q$, so $r = 5\%$ at $Q = 300$. Foreign savers lend an extra \$100 billion at every rate. Find the new rate.
- New supply: $r = 2 + 0.01(Q - 100) = 1 + 0.01Q$.
- $1 + 0.01Q = 8 - 0.01Q$, so $Q = 350$ and $r = 4.5\%$. The inflow lowers the real rate.
Answer: 4.5%
Common mistake
Expecting a higher interest rate to weaken a currency because borrowing costs more. It draws foreign savers, who must buy the currency first, so the currency appreciates. Check: who wants this country's assets now, and what do they need to buy them?