Question

Suppose that the nominal interest rate on threemonth Treasury bills is 8 percent in the United States and 6 percent in the United Kingdom, and the rate of inflation is 10 percent in the United States and 4 percent in the United Kingdom. a. What is the real interest rate in each nation? b. In which direction would international investment flow in response to these real interest rates? c. What impact would these investment flows have on the dollar's exchange value?

Short answer

a) The Real Interest Rate: US = -2%, UK = 2%. b) Investments would flow from the US to the UK. c) These investment flows would decrease the dollar's exchange value.

Step-by-step solution

Calculate the Real Interest Rate

To find the real interest rate, subtract the rate of inflation from the nominal interest rate. The real interest rate in the United States is \(8\% - 10\% = -2\%\). The real interest rate in the United Kingdom is \(6\% - 4\% = 2\%\).

Analyze International Investment Flow Direction

With higher real interest rate, the United Kingdom becomes more attractive for investors looking for better returns. Thus, international investment would flow from the United States to the United Kingdom.

Analyze the Impact on Dollar's Exchange Value

Increased investment in the UK means increased demand for British pounds and reduced demand for US dollars. Hence, the dollar's exchange value is expected to decrease.

Key concepts

Nominal Interest Rate

The nominal interest rate represents the percentage at which investment returns are calculated, excluding any adjustments for inflation. It's the basic rate offered before accounting for the impact of rising prices. For example, when you read that the United States offers a nominal interest rate of 8%, this figure tells you the rate of return you could expect on treasury bills without considering how inflation might erode your purchasing power.

Nominal interest rates can be:

• High, suggesting higher returns for savings and investments, but possibly indicative of high inflation.
• Low, indicating smaller returns but potentially lower inflation.

To get a true understanding of what your investments are worth, you need to consider the real interest rate, which is adjusted for inflation. This adjustment is crucial because even if your investment grows by a certain percentage, the actual value gained could be less due to the current rate of price increases.

International Investment Flow

International investment flow involves the movement of capital and investments from one country to another, driven by the search for higher returns. This flow is influenced heavily by differences in real interest rates. When a country offers a higher real interest rate, it becomes a magnet for investors as they seek better returns on their investments.

In the context of the original problem, the United Kingdom has a real interest rate of 2%, compared to the United States’ -2%. This discrepancy means:

• Investors will likely move capital from the US to the UK.
• The flow of investment towards the UK could strengthen its economy by increasing the availability of funds for businesses and government initiatives.
• Conversely, the US might see lower investment, affecting economic growth negatively.

Understanding these dynamics helps predict how shifts in international investment can impact a country's financial health and currency strength.

Exchange Rates

Exchange rates define how much one currency can be exchanged for another in the global market. They are influenced by numerous factors, including international investment flows. When investments are redirected from one country to another, as seen with the US and UK in the example, the exchange rates will likely respond to these flows.

Here's how it works in our scenario:

• As investments flee the United States in favor of the United Kingdom, demand for British pounds goes up.
• This increased demand makes the pound stronger compared to the US dollar.
• The US dollar, facing less demand, decreases in value relative to the pound.

A weaker dollar can have various implications, such as making US exports cheaper and imports more expensive, possibility impacting trade balances and economic policy decisions. Understanding this interplay between investment flow and exchange rate is vital for grasping the complexities of global economic interactions.