Capital Mobility and World Interest Rates Under Open Economy
In case of a small open economy, we assume perfect capital mobility. By "small" we mean that an economy has very small share in the world markets. It has a negligible effect on interest rate. By perfect capital mobility, we mean that residents of a country have full access to goods and services and specially financial markets of the world. Because of this assumption of perfect capital mobility, the interest rate in our small open economy, r, must equal the world interest rate say, r*, the real interest rate prevailing in world financial markets: r = r*. This means that people in this small open economy will never borrow at more than r rate in home country.They will shift to international markets to borrow or invest, in case r > r*. Thus, we can say that, the interest rates in a small open economy are determined by the world markets. World interest rate (r*), on the other hand is determined by equilibrium of world saving and world investment.
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