DB 4 – response
Please write one separate response to each of the 2 posts below.
Post #1 (Ryan):
Question: If the interest rate in the US is 5% and in Mexico it is 10%, where will capital inflow and outflow occur in both countries? Now, what will happen to both currencies? Also, how will this affect both of their GDP and net exports?
If the interest rate in the US is significantly lower than in Mexico, than capital inflow will come to the United States and capital outflow will likely come from Mexico as investors want to take advantage of ‘cheaper’ money. This has been the Federal Reserve’s monetary policy for the last couple decades, as a low IR will encourage borrowing. Borrowing will then influence spending and economic activity, even if it is not always practical.
A currency with a lower interest rate tends to realize more demand, but also an increase in supply. Following the Federal Reserve, this policy has devalued the dollar tremendously, and only recently with QE slowing down, has the dollar taken a step in the right direction. The Mexican currency is likely to see less borrowing activity, which should make it more scarce and influence the value to increase, especially if large amounts of money are being moved into the US economy.
GDP is a measure of the “final value of all goods and services that are produced within a country in a given time period” (Krugman, Obstfeld, & Melitz, 2012). So, with that said, GDP conditions are likely to improve with more incentives to enter the US market and borrow money for speculation or investment. The ‘cheap’ money will also favor net exports for the US to bring more imported goods. Mexico’s GDP will show capital outflows which will likely lower their net export numbers.
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Post #2 (Brian):
Question: If the interest rate in the US is 5% and in Mexico it is 10%, where will capital inflow and outflow occur in both countries? Now, what will happen to both currencies? Also, how will this affect both of their GDP and net exports?
I personally believe that if the interest rate in the US is 5% and in Mexico is 10%, there will be capital inflow in US and outflow in Mexico. The main reason I came to this conclusion is the basis of bank borrowing. Banks would prefer to have borrowers with higher credit scores even if their ROI will be smaller. This means that since the US’s credit is AAA and Mexico’s is BBB that most investors will prefer dealing with the guarantee of payment even at the lower ROR (Credit Rating, 2015). If investors buy into the US creating a capital inflow then the currency will increase in value also. When more and more invest in the US this leads to a “strong” dollar because the demand is high and supply low. When the dollar is considered strong then its a friend for importers (Exchange Rates and Exchange: How Money Affects Trade, 2015). To show an example, lets say that the exchange rate between the US and Mexico is 1 dollar = 2 pesos. Before investors choose to invest in the US it was 1 dollar = 1 peso. Now that there has been more capital inflow into the US the dollar has become more valuable because of the shortage by the new investments. Lets say that the US and Mexico both produce oranges. Before the investment Mexico would import the oranges from the US at 1.5 dollar/peso an orange. After the investment and the change of currency it would cost Mexico 3 pesos per orange to import from the US, meanwhile Mexico could produce the oranges themselves for 2 pesos. Therefore, by strengthening the value of the dollar caused by the capital inflow we have inadvertently decreased exports. This example shows the effect capital inflow could have on imports and exports. When we discuss imports and exports GDP is not far away so by decreasing our exports and increasing our imports, caused by the capital inflow, we inadvertently created a lower GDP then before, specifically speaking about trading not overall GDP.
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