AP_Krugman_Textbook

Underlying Determinants of International Capital Flows

The open - economy version of the loanable funds model helps us understand interna-
tional capital flows in terms of the supply and demand for funds. But what underlies
differences across countries in the supply and demand for funds? And why, in the ab-
sence of international capital flows, would interest rates differ internationally, creating
an incentive for international capital flows?
International differences in the demand for funds reflect underlying differences in
investment opportunities. In particular, a country with a rapidly growing economy,
other things equal, tends to offer more investment opportunities than a country with a
slowly growing economy. So a rapidly growing economy typically—though not always—
has a higher demand for capital and offers higher returns to investors than a slowly
growing economy in the absence of capital flows. As a result, capital tends to flow from
slowly growing to rapidly growing economies.
The classic example is the flow of capital from Britain to the United States, among
other countries, between 1870 and 1914. During that era, the U.S. economy was grow-
ing rapidly as the population increased and spread westward and as the nation indus-
trialized. This created a demand for investment spending on railroads, factories, and so
on. Meanwhile, Britain had a much more slowly growing population, was already in-
dustrialized, and already had a railroad network covering the country. This left Britain
with savings to spare, much of which were lent to the United States and other New
World economies.
International differences in the supply of funds reflect differences in savings across
countries. These may be the result of differences in private savings rates, which vary
widely among countries. For example, in 2006, private savings were 26.5% of Japan’s
GDP but only 14.8% of U.S. GDP. They may also reflect differences in savings by gov-
ernments. In particular, government budget deficits, which reduce overall national sav-
ings, can lead to capital inflows.

module 41 Capital Flows and the Balance of Payments 417

Section 8 The Open Economy: International Trade and Finance

4%

0

SUS

DUS

International

equilibrium

interest rate

Quantity of

loanable funds

Interest

rate

EUS

(a) United States (b) Britain

0

SB

DB

Quantity of

loanable funds

Interest

rate

EB

Capital inflow to

the United States

Capital outflow

from Britain

4%

figure 41.4 International Capital Flows

British lenders lend to borrowers in the United States,

leading to equalization of interest rates at 4% in both

countries. At that rate, American borrowing exceeds

American lending; the difference is made up by capital

inflows to the United States. Meanwhile, British lending

exceeds British borrowing; the excess is a capital

outflow from Britain.