Suppose that the interest rate is 4% in the United States and 7% in Japan. Assuming financial assets in the two countries carry equal risk:

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Consider the situation where two countries offer different nominal interest rates but have assets of equal risk. This creates an incentive for capital to move from the country with the lower return to the country with the higher return.
Option 1: 'interest rates in Japan will increase.' This is a possible outcome if capital flows into Japan raise demand for assets there, pushing up prices and thus lowering yields until equilibrium is reached. However, saying rates will necessarily increase ignores the role of capital mobility and may wait on other factors to adjust; it’s not the only immediate mechanism, since returns adjust through capital flows and asset prices as well as monetary policy.
Option 2: 'the capital flow between Japan and the United States eventually will render the interest rates equal.' This captures the classic prediction from financial arbitrage: when assets carry equal risk, investors will move capital toward the higher-yielding country, increasing demand and prices there and decreasing the yield, while the other country experiences the opposite adjustment, until a common internal rate of return is achieved. The process relies on expected returns converging, not on one side alone changing policy without consequence. This option aligns with the intuition of uncovered or covered interest parity depending on exchange rate expectations, with the general outcome of convergence in many standard analyses.
Option 3: 'the interest rates in both countries will remain unchanged.' If capital is free to move and risk is equalized, the incentive to earn a higher return would prompt movement; therefore, with no other frictions, rates are unlikely to remain unchanged. This option contradicts the mechanism by which arbitrage opportunities are eliminated through capital flows.
Option 4: 'interest rates in the United States will decrease.' A decrease in U.S. rates would reduce the spread, but the direction of adjustment depends on capital mobility and policy responses in both countries. It is not the only or guaranteed immediate outcome; suggesting a unilateral decrease oversimplifies the dynamic and ignores how capital would reallocate in response to a higher Japan yield.
In summary, the core idea is that if risks are equal and investors seek higher returns, capital will move toward the higher-yielding market, and the resulting capital flows will tend to narrow the interest-rate gap across countries until an equilibrium is reached. The second option best encapsulates that mechanism, while the other options describe possible but less comprehensive or less likely instantaneous outcomes given unrestricted mobility and comparable risk.

Suppose that the interest rate is 4% in the United States and 7% in Japan. Assuming financial assets in the two countries carry equal risk:

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Suppose that the interest rate is 4% in the United States and 7% in Japan. Assuming financial assets in the two countries carry equal risk:

View Explanation

Log in for full answers

Similar Questions

The French interest rate is lower than the international market rate, and the Italian interest rate is higher than the international interest rate. Capital will flow from ______________ to _______________ if it can cross international boundaries.

Which of the following is not a determinant of capital flows?

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