Question

Assume that we do not know the preferences of a country, and say that it is a country with high debt. If world interest rises in this open economy with no capital controls, what do we expect in current account? Show in steps.(no utility curves, think about Current account = Savings -Investment, and Investment is negatively related to interest rate increases)

Answer 1

An increase in the world interest rate will lead to capital flight from the home country to the places where the interest rates are high and will cause a current account deficit.

Let's assume home country to be the US and interest rate in the home country to be 10%. If the world interest rate increase to 12% then the return on the savings in the foreign market increased by 2%.

If a person does some saving in the home country he will only get a return of 2% and if he saves the same amount in Frace he will get a return of 12% (higher world interest rate).

The person will just move his money from the US to France, This will cause a capital flight to France.

People will withdraw their money from the US and deposit it in France.

More outflow and less inflow will cause a current account deficit.