Question 11
As the real interest rate in the domestic loanable funds market increases,
(1) the inflationary premium will rise and the money rate of interest will decline.
(2) the cost of purchasing goods and services during the current period will decrease.
(3) the net inflow of capital from abroad will increase.
(4) a trade surplus will occur.

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UpStudy AI · Accepted Answer

1. We know that the domestic nominal interest rate, $$ i $$, is given by

$$
i = r + \pi^e,
$$

where $$ r $$ is the real interest rate and $$ \pi^e $$ is the inflationary premium (expected inflation). An increase in $$ r $$ would generally cause an increase in $$ i $$ if $$ \pi^e $$ remains constant. Thus the assertion in (1) that the money rate (nominal rate) declines is incorrect.

2. The higher real interest rate makes saving more attractive relative to consuming today. This means that the opportunity cost of current consumption rises rather than declines. Therefore, the cost (in terms of lost future consumption) of purchasing goods and services today increases, not decreases as stated in (2).

3. An increased domestic real interest rate raises the return on investments within the country. This makes domestic financial assets more attractive to foreign investors. Consequently, we expect an increased net inflow of capital from abroad, so (3) is correct.

4. The increased inflow of foreign capital is typically associated with a current account deficit, not with a trade surplus. A trade surplus would imply that exports exceed imports, but capital inflows (as seen here) are generally linked with a trade deficit. Thus, (4) is incorrect.

$$
\textbf{Conclusion: Only statement (3) is correct.}
$$
When the real interest rate increases, the net inflow of capital from abroad will increase.

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