Can anyone explain to me why a capital flight from a country increases the demand for loanable funds in that country. Here's the standard explanation. https://policonomics.com/lp-open-economy-loanable-funds/

In this explanation the NCO shifts left (lower NCO) & the demand curve for loanable funds goes right (increases at every level of r). I get I+NCO = demand curve. But if I talk it through, then my mental modle always comes up with - capital flight, no one wants the currency less people want the loanable funds so at any R demand is less, hence a shift to the left of the demand curve - not right.

I have a second problem scenario which I can't make fit the model. Gvt encourages investment throught tax credits. Demand curve must shift right in the loanable funds market, but surely NCO would shift to the left (or is therejust a move leftwards along the curve?)...thus according to the textbooks shifting the D loanable funds left not right.

None of the textbooks really explain why a capital flight means people want more "loanable funds". And if a country becomes more attractive to invest in the demand for loans in that country must go up, not down.

I just can't get my head around this 3 market model. What's wrong with my thinking.


1 Answer 1


This 11 page reference describes capital flight on page 10:


The conventional logic for capital flight and demand for loanable funds:

Since net capital outflow is also part of the demand for loanable funds, (during capital flight) the demand for loanable funds rises.

If I understand correctly, according to conventional economic logic, the act of saving means units in the economy spend less income on consumption and this saving increases the supply of loanable funds. This is the primary assumption which is challenged by the so-called heterodox economic logic. The heterodox logic argues that government deficit spending policy and market finance deals provide new funds from "thin air" for investment and consumption activity without anyone having to save funds from prior income sources. In other words spending decisions with finance and government budget policies drive the mix of investment and consumption. If spending for investment and consumption go down then so does future income and saving as the outcome or result of those prior financial planning decisions.

Supposedly the equilibrium demand for loanable funds expressed as the sum of spending for investment and the net capital outflow.

The way I think about this is top down as follows:

National Wealth (W) = Non-financial Assets (K) - Foreign Financial Claims (FFC)

Domestic investment means the increase of Non-financial assets K regardless of the finance source. Capital flight means foreigners are trying to reduce their financial claims held against the domestic non-financial assets. The foreign financial claims are financial assets which are issued as liabilities of governments, banks, or other units in the economy during the processes of international trade and investment. In the modern world international trade is only partly coupled to international investment flow so capital flight can disrupt trade and other features of the domestic economy.

The domestic loanable funds market would be used to finance investment projects which increase K over time as investments become new wealth. But the net domestic financial wealth is zero because for every financial asset there is a matching liability in another economic unit. Therefore the valuation of non-financial assets K is the wealth of the nation less the foreign financial claims against this wealth.

I don't think all the conventional economic logic necessarily holds if one examines how domestic and international trade occurs in the accounting context with government deficit policies. I do not agree that government deficits reduce supply of loanable funds for example. The United States government does not have a net worth comparable to any other unit in the history of the world as far as I am concerned because its role is not to save for retirement nor is it to profit from commercial activities. The United States holds vast tracks of land with mineral wealth which are not given a value under national accounting customs. So the SNA Integrated Macroeconomic Accounts (SNA-IMA) show the United States government with large and growing negative net worth since the 1970s and yet there has been no significant capital flight from US dollars. The factor which stabilizes global trade is US government budget deficit increases to prevent a flight away from US dollars when the dollar based financial markets threaten a systemic crisis.

  • $\begingroup$ The quote that you put in your 1st para is the most common explanation. - which isn't really explaining things. I think I've found the "mainstream" explanation in Mankiw (Economics 4th edition p615): "When net capital outflow increases there is greater demand for loanable funds to finance these purchases of capital assets abroad." So my understanding here is that foreign investors leave (that wouldn't necessarily add to demand for loanable funds) but the domestic investors are leaving to thus increasing the demand. Finally, I tend towards the situation in the first para. MMT right $\endgroup$
    – Studi
    Commented Dec 14, 2020 at 12:46
  • $\begingroup$ @Food Consider elastic money supply in Nation A and B where bank loans plus securities plus reserves create deposits plus bank equity claims. Deposits A and B are the respective money supply. International trade causes a swap of claims to deposits A/B via FX markets but does not change the levels of A or B. Balanced trade means FX positions net to zero. Persistent trade imbalance would wind up increasing FX positions unless a mechanism exists to reverse the FX without trade (foreign investment in domestic markets?). Bank loans are elastic part loanable funds. Does flight trigger loan demand? $\endgroup$ Commented Dec 14, 2020 at 15:16
  • $\begingroup$ Sorry, I never commented. I think I'm just too stupid. "... reverse the FX without trade (foreign investment in domestic markets?)." - The drying up of foreign investment would then lead to a fall in the demand for loans (they're not investing). However there are also domestic investors and they would demand loans to invest in foreign capital. So surely it depends who is "bigger". In most cases I would assume the rest of the world is bigger thus leading lowering demand for loans. Which is the exact opposite of what you want to explain to me! $\endgroup$
    – Studi
    Commented Apr 29, 2021 at 9:55

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