Suppose there are two countries, Austrailia and Europe. The interest rate in Aus

Question

Suppose there are two countries, Austrailia and Europe. The interest rate in Australia and Europe is originally 3% in each country. The Federal Reserve increases interest rates in Austrailia causing the interest rate to increase to 4%. The Bank of Europe (the central bank of Europe) maintains the 3% interest rate. Explain the capital flows that will take place between the two countries and how you expect this will affect the balance of trade. Assume we live in a world of perfect capital mobility. Also need to discuss exchange rate movements.

Explanation / Answer

The capital flow will take place from the European Market to the Australian Market. As we have assumed there is a perfect capital mobility that means for the investors in Europe to invest in Australia is same as investing in the local European bank. Now, because the European banks have kept the interest rates same that means the savings in European banks will only get a return of 3% but the same saving in Australia will get a return of 4%. So, to get a higher return the investors in Europe will move their funds to Australia causing an outflow of funds for Europe and inflow of funds for Australia.

The Australian balance of payment might show a surplus and European Balance of payment will show a deficit.

An outflow of cash will cause the European currency to depreciate against AUD. Due to the outflow, the demand for the Euro is down and everybody wants to dump it and get more Australian dollar causing a decrease in demand for Euro and increase in demand for AUD. This will cause the AUD to appreciate against the Euro and Euro will depreciate against the AUD.  

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