Real Interest Rates and International Capital Flows

Savers and bondholders do not care about national borders, they care about return. If a country raises its real interest rate relative to the rest of the world, its bonds and deposits suddenly pay more after accounting for inflation. Foreign savers notice and shift money in, buying that country's financial assets. This inflow of foreign financial capital is called a net capital inflow, and it rises whenever the domestic real interest rate climbs above rates available elsewhere.

This matters because a high real interest rate is not a trophy. It can mean a government is borrowing heavily and has to offer a juicy rate to attract lenders, or that investors see risk and demand compensation, or that expected inflation is baked into the nominal rate. Two countries can share the same nominal rate, but if one has higher expected inflation, its real rate is lower, so capital flows toward the country with the lower inflation and higher real return, not the higher nominal number. Real rates, not nominal ones, drive the decision.

This connects directly to the loanable funds market. Domestic saving is one source of supply there, but net capital inflows are a second source: foreign saving flowing in adds to the total funds available for domestic investment at a given real interest rate. That inflow is also the financial mirror of the current account deficit covered elsewhere in this unit. Money flowing in to buy bonds must flow in on the financial account, balancing a trade deficit on the current account.