Capital Flight: Foreign Savers Pull Out
Foreign investors lose confidence and move their saving abroad, shrinking the supply of loanable funds and driving the real interest rate up.
Capital Flight: Foreign Savers Pull Out
Loanable Funds MarketForeign investors lose confidence and move their saving abroad, shrinking the supply of loanable funds and driving the real interest rate up.
Equilibrium at Quantity of Loanable Funds 73, Real Interest Rate (%) 5
Start at Equilibrium
The market opens in equilibrium with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. Part of the supply curve here is foreign saving: lenders abroad who have bought domestic bonds because the return looked good for the risk they were taking.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
Capital Flight: Foreign Savers Pull Out, step by step
- 1
Start at Equilibrium
The market opens in equilibrium with the real interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis. Part of the supply curve here is foreign saving: lenders abroad who have bought domestic bonds because the return looked good for the risk they were taking.
- 2
Foreign Savers Withdraw
Unrest and doubts about repayment make lending here look risky, so foreign investors sell their holdings and take the proceeds abroad. That lending disappears from the market at every real interest rate, and the supply of loanable funds shifts left. Domestic borrowers still want to build the same projects, so the demand curve does not move.
- 3
The Real Interest Rate Rises
Borrowers now compete for a smaller pool of funds, so the equilibrium slides up along the unchanged demand curve to where it meets the new supply curve. The real interest rate rises and the equilibrium quantity of funds borrowed and lent falls. Higher rate with lower quantity again signals a supply shock rather than a demand shock.
- 4
Domestic Investment Falls
Firms facing more expensive credit shelve projects, a movement up along the demand curve. Note what makes this different from a domestic saving shock: households here did not change their behavior at all, and the squeeze arrived entirely from abroad. The financial account outflow that raised the real interest rate has a matching move toward a current account surplus on the other side of the ledger.
Where it ends up
Capital flight withdraws foreign saving from the loanable funds market, raising the real interest rate and reducing domestic investment.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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