understand why real interest rates should be approximately the same in all countries, a result known as interest rate parity; and
be able to explain why a nominal interest rate difference between countries should have no impact on the exchange rate except insofar as it reflects a real interest rate difference.
18.1 Why are Real Interest Rates Similar In Different Countries?
In chapter 15 we saw that a rise in a country's real interest rate, with no change in other countries' real interest rates, causes a net capital inflow. We discussed how this would affect the balance of payments and consequently influence other economic variables of interest. One impact of the net capital inflow that we did not discuss was its effect on the real interest rate itself.
Suppose, for example, that the real interest rate in a small country such as Canada rises, creating a net capital inflow into Canada. This puts downward pressure on the Canadian real interest rate. This result occurs for two reasons. First, foreigners will want to invest in Canadian bonds to obtain the higher return, so the demand for Canadian bonds increases, bidding up Canadian bond prices and thereby lowering the Canadian real interest rate. Second, Canadian firms selling bonds will find it cheaper to raise capital in other countries, so they will remove their bonds from the Canadian market and take them to foreign bond markets. The fall in the supply of bonds on the Canadian market also causes the price of Canadian bonds to rise, thus lowering the Canadian real interest rate.
The bottom line here is that a rise in the Canadian real interest rate sets in motion forces that push this interest rate back toward the ''world" real rate of interest. In general, however, these forces will not succeed in pushing the Canadian interest rate all the way to the "world" real rate because the relationship between the "world" real rate and a specific country's real rate is only approximate.
18.2 Why Approximately?
The "world" real rate is a fictitious rate, thought to be determined by activity in a few large, stable financial markets such as those in the United States, Germany, Great Britain, and Japan. For expositional convenience, however, we consider the world real rate to be the rate prevailing in the United States, keeping in mind that the U.S. real rate can in reality be af-
