How interest rates affect interest rates, financial flows, and exchange rates

What we're going to do in this video is try to think of the chain of events that would happen if the supply of loanable funds were to increase in the United States. The way that that could happen is, let's say, the Federal Reserve were to, so to speak, print money and then use that money to buy treasuries in the U.S. So it's inserting those Federal Reserve notes into the quantity of loanable funds.

Well, what would happen is that the supply of loanable funds would shift to the right. So our new supply would look like this. I'll call that S prime. Then we'd have a new equilibrium price of those funds, which we would call our real interest rate. So then we get to R prime. Our real interest rates have gone down, and we have a higher quantity of money that is being loaned, Q prime.

But what would be the effect of that? What would be the effect of that relative to other countries? I'm just picking Japan here as another country, but this could be the case with many other countries where they have relatively free flows of goods and financial capital. To help us think through that, I drew the balance of payments for each country. The balance of payments is made up of the current account, which is talking about the flows of goods and services. Then you have what's sometimes called the capital account, sometimes the capital and financial account, which is talking about the flow of, oftentimes you could think of it as financial investment or investments of some kind, or the flow of funds.

So pause this video and think about what would happen. Well, if the real interest rates go down in the United States and we're assuming that all else is equal in every other country, well then you have a situation where in Japan the relative real interest rates are now higher. So relative real interest rates are higher now. In general, people might want to say, “Hey, if I can get a higher or higher-than-before relative real interest rate, it might not be absolutely higher, but it's higher than it was before relative to the United States.” Well, that might increase the financial flows from the United States to Japan.

So you might have some more people, not everyone, but some more people than before who want to take their dollars, convert it into yen, and buy financial assets in Japan where they can get that relatively now higher real interest rate. Well, if these folks are converting from dollars to yen, what's the immediate effect of that? Well, it will increase demand for the yen, and so the price of the yen in dollar terms will go up.

Or another way to think about it is this is going to cause the dollar to depreciate relative to the yen. So we're just going to put that aside right over here because this is going to have other implications. But that dollar is used to buy yen, and then those investors will maybe buy Japanese bonds. So what's happening? Well, we're talking about the transfer of financial assets.

In the United States, the capital and financial account will go down. This will go down. You could think of it as being debited. And in Japan, they are getting an increase in financial assets; people are investing more in Japanese bonds, however you want to think about it. So that increase in funds goes up, and so this is getting credited.

Now, in other videos, we've talked about how over time the balance of payments tends to balance out. If one side is getting debited, the other side is getting credited or vice versa. So how is that going to work out in this situation? Well, that all goes back to the fact that the dollar has depreciated relative to the yen. If the dollar depreciates relative to the yen, what is that going to do?

Well, now American goods are relatively cheaper than they were before, cheaper in Japan, and Japanese goods are more expensive in the U.S. So what is going to happen? Well, in that situation, that means that the U.S. is going to export more to Japan; their goods are now cheaper in Japan, and Japanese goods are now more expensive in the U.S. So they're going to buy fewer Japanese goods and export more American goods.

So what's going to happen on our current account? Well, if you're exporting more, that means your current account goes up. It is going to be credited. Then the opposite's going to happen to Japan relative to the U.S. It's going to export less and import more, so its current account is going to be debited.

Now, economies are complex things, and what I've just done is a little bit of a simplification, but these are the general trends that you would expect. Other things that you might expect are, well, if you have this flow of financial capital into Japan, well, that might increase their loanable funds, and so their real interest rate might eventually go down.

All of these cycles would keep going and reverberating back and forth over time. But this is the general chain of events that you might expect: that the interest rates in Japan will become relatively higher. So you have the flow of financial funds going from the U.S. to Japan.

In the process, when they convert from dollar to yen, the dollar is going to get cheaper, the yen's going to get more expensive, the American capital and financial account goes down because you have this net outflow of financial funds. But because of the depreciation of the dollar, the U.S. is now importing less and exporting more.

Now, a question is, is this good or bad for either country? Well, it depends what the country's goals are. This might be good for the U.S. if their goal was to export more American goods, or it might be bad for the U.S. if they said, “Hey, now Japanese goods are more expensive,” and maybe they're dependent on some type of Japanese goods in some way, shape, or form.

That might not be the case with the U.S., but in another country, let's say they're dependent on oil from other countries, or they're dependent on military hardware from other countries. If those things become more expensive— or food— that might make it a lot harder for their citizens.

So it's an interesting thing to think about whether this is good or bad and how all of these things fit together.