When the law of one price is applied to interest rates, do interest rates differ much across national borders?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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When the law of one price is allowed to work, interest rates will not differ to a great degree across national borders.  Instead, interest rates should tend to converge.  This is particularly true since there are very low transport/transaction costs for financial transactions.

If there are different interest rates across countries, the market should work to reduce those differences.  Investors will want to put their money into the countries that have high yields.  As they do so, the interest rates in the various countries will be reduced.  Historically, therefore, times when capital is allowed to flow freely across borders are times when interest rates tend to converge.

Interest rates, then, should not differ widely from country to country as long as the law of one price is allowed to work.

 

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