Adding the Net Flow of Funds by the ROW to the Total Supply of funds
By adding the net investments by foreign funds to the domestic supply of funds by household, governments and firms we get the total supply of funds – the funds flow from all the four sectors. So if the domestic investments is say 100 billion at 6% and foreign investment is 50 billion, the total supply of lending would be 150 billion. If interest rates fall to 4% domestic supply would fall to 60 billion but net investments by foreigners would fall to -10 billion making the total investments at 50 billion. The total supply is therefore reduced by the outflow of funds from the domestic market.
When we add the demand curve to the diagram we see that at the equilibrium rate of 6% the demand for funds is equal to the total quantity supplied, which in turn is equal to the quantity supplied by domestic lenders plus net lending by foreigners.
Shifts in the demand curve affect the net lending or investments by foreigners. For example if the government deficits increases causing the government borrowing to increase the demand curve shifts to the right. This causes the equilibrium rate to increase from say 6% to 8%. At 8% domestic lending increases as well as lending by foreigners increases causing an increase in total lending. Therefore we see that higher government deficits puts an upwards pressure on interest rates that causes an increase in foreign investments.