Why does negative NCO reduce demand for loanable funds?

Answer 1

Hello Freddie,

Let's break down how negative Net Capital Outflow (NCO) reduces the demand for loanable funds step by step:

1. Definition of Negative NCO: Negative NCO occurs when a country borrows more from foreign sources than it lends to them. This means that the country is relying on foreign savings to finance its investment beyond what its domestic savings can cover.

2. Effect on Domestic Savings: Since the country's investment exceeds its domestic savings, there is a shortfall in available funds for investment from domestic sources alone.

3. Need for Foreign Financing: To bridge this gap, the country turns to foreign sources to borrow funds. Foreign investors are willing to lend to the country, attracted by investment opportunities or other factors such as higher interest rates compared to their own countries.

4. Increased Availability of Foreign Funds: With negative NCO, the country gains access to additional funds from abroad. These foreign funds supplement domestic savings and increase the pool of loanable funds available for domestic borrowers.

5. Impact on Domestic Borrowing: The availability of foreign funds at potentially lower interest rates reduces the demand for loanable funds domestically. Borrowers, whether they are businesses seeking capital for expansion or individuals looking for loans, may prefer to borrow from foreign sources due to the cheaper financing options available.

In summary, negative NCO reduces the demand for loanable funds domestically by increasing the availability of foreign capital.