I want you to imagine that you had a million dollars in hand (I actually hope you see that as a possible reality :]) and you made that million dollars out of pure hard work, sweat and tears. It’s great that you have all that cash now but you think to yourself, “Damn, do I really wanna spend it all away? I better leave some for the future and even for my next generation so that they can pursue the success that I had!” So you decide not to splurge the cash away on that new car. You walk out of the Lamborghini showroom and your conscious mind tells you that you’re a smart guy. Putting your money into a “Kong Guan” biscuit tin or under your bed ain’t gonna make your money grow, it’ll make it smaller due to inflation and taxes! Shit! You’re in trouble! How in thee blue hell are you gonna protet your hard-earned money?
Then, a guy in a suit comes up to you and says, “Hey there, rich fella! I’m from Quickienomics Finances and I see that you could use some of my help!” Curiously, you ask this smart-lookin’ fella what he has to offer. He says that he’s an investment banker and has 2 investment products to offer you. You can either put your money into Project A or Project B. He then explains that Project A yields a 3% return on your million dollars which mean you get back 1.03 million bucks at the end of a year. “Hmmmm, pretty awesome to gain $30,000 from simply lending this guy my money.”
When it comes to Project B, the Quickienomics guy says that it will yield a return of 5% instead! Your eyes sparkle at the thought of gaining $20,000 MORE with Project B! What an amazing deal! You say YES to project B but there’s a problem. This investment is located in England so you have no choice but to change all your money into British pound! Your action just caused a sudden increase in demand for the British pound! Speculators around the world are thinking that maybe, JUST maybe, the British pound is gonna appreciate! Well, it’s a maybe because it depends on what the British government thinks about their exchange rate policy: Fixed or Flexible?
Can you imagine what would happen if the Quickienomics investment banker offered this opportunity to the entire world? Everybody would put their money into Project B and nobody would want Project A! So how do we prevent this large inflow into Project B and making all other investment projects worthless? The answer is simple, we just gotta make sure all investment projects have the same interest rates! This is known as the uncovered interest parity. But of course in reality, this doesn’t happen because we gotta factor in risk profiles, exchange rates and other important aspects of investment. But let’s just stick to the fact that in a simple world, to prevent massive inflows of capital into local or foreign assets, interest rates on these assets have to be same. And that is the principle behind Perfect Capital Mobility.
At the end of this video, you should be able to:
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