The Effects of Shifts in the CF(r) Curve on the Long-Run International Finance Diagram Are Not Ambiguous After All

  • Assume that the Supply of Loanable Funds curve is upward-sloping
  • Assume that the I(r) curve is downward sloping. 
  • Both of these assumptions are crucial to what follows. 
  • Now, Consider a case when the CF(r) curve shifts out. (After you read the rest of this post, make sure you work through the case when the CF(r) curve shifts back for yourself. Actually, in general you should always work through the opposite directions of things as part of your studying. The simplest way to make an exam question is to do the opposite direction from what was covered in class.)
  • Since the Demand for Loanable Funds is the horizontal sum of the I(r) curve and the CF(r) curve, the outward shift in the CF(r) curve also shifts the Demand-for-Loanable-Funds out. 
  • This raises the interest rate r.  
  • The increase in r moves things up and left along the CF(r) curve. 
  • It might seem that the outward shift in the CF(r) curve combined with a shift up and to the left along the CF(r) curve might make the direction the quantity of CF goes ambiguous. But not so! 
  • Since the I(r) does not shift, the increase in r lowers the quantity of investment I. 
  • Since the Supply-of-Loanable-Funds curve does not shift, the increase in r raises the quantity of saving S. 
  • S = I + CF, since physical investment and sending funds abroad with CF are the two possible uses of overall national saving. (Remember that national saving is household saving + corporate saving + government saving.)  
  • Since quantity of S increases, while the quantity of I decreases, the only way that the equation S = I + CF can be satisfied is for the quantity of CF to increase. 
  • Thus, the quantity of CF moves in the same direction that the CF(r) curve shifts. 
  • The quantity of CF determines the location of the vertical Supply of Dollars. With the quantity of CF increasing, the Supply of Dollars curve, which is vertical at the quantity of CF, shifts to the right. 
  • A very similar analysis can be used to analyze shifts in the I(r) curve. Try it!