How does adjustment of interest rates in an open economy impact net capital flows?

In the context of an open economy, interest rates play a crucial role in influencing net capital flows. When interest rates are adjusted, they affect the returns on investments in that economy compared to those in foreign markets. If a country raises its interest rates, it typically becomes more attractive to foreign investors seeking higher returns, which can lead to an inflow of capital. Conversely, lower interest rates may motivate domestic investors to seek opportunities abroad, resulting in increased capital outflows.

The option indicating that interest rate adjustments serve to stabilize capital outflow reflects the idea that higher interest rates can mitigate the outflow of capital by making domestic assets more attractive to both local and foreign investors. This can stabilize net capital flows as it encourages more investment within the domestic economy.

Understanding this relationship is essential because it illustrates how monetary policy can impact international capital mobility and exchange rates. By adjusting interest rates, a country can influence both domestic investment levels and the attractiveness of its currency, thus affecting net capital flows accordingly. Balancing these flows is crucial for maintaining economic stability in an open economy.