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Net Investment by Foreigners

Effect of Net Investment by foreigners on the Supply curve

The supply curve relates net lending or investing by foreigners to interest rates in the US or any other foreign destination. The supply curve has a positive slope which means that higher the interest rates higher the net investment or lending. If the interest rates in the US falls vis a vis interest rates in other countries the net lending or investing becomes negative. More funds will flow from the US asset markets to other country markets.

We should also keep in mind that there are dollar denominated markets outside the US which are called the Eurodollar markets. The same concepts apply to these dollar denominated markets as well. The same theories apply to dollar denominated markets as well.

If the net lending by foreigners was say a 100 billion when interest rates were 6% in the US, the net lending at 4% would fall to zero, and when interest rates fall below 4% to 2% the net lending would fall to -50 billion, which implies an outflow of funds from the US or net borrowing.

Any other factors that affect net investments by foreigners cause the supply curve to shift.

For example if the foreign interest rates rise all other factors remaining the same, investments in the US become less attractive at any level of interest rates causing the supply curve to shift left

If the political risk overseas increases, investing in safer countries such as the US at all levels of interest rates causes a shift in the supply curve to the right.

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.

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