In a large open economy, how does the interest rate adjust to ensure domestic savings are balanced?

In a large open economy, the interest rate adjusts to ensure that domestic savings are balanced with domestic investment and net capital outflow, which is why the correct answer is that the interest rate must equal domestic investment plus net capital outflow.

In an open economy, the total amount of savings (both domestic savings and foreign savings) finances both domestic investment and any capital that leaves the economy (net capital outflow). When interest rates change, they influence the level of savings and investment. An increase in interest rates generally encourages more domestic savings and might reduce domestic investment due to higher borrowing costs, while also impacting net capital flows.

A balance is achieved when the amount saved domestically matches the amount invested domestically plus the funds that are flowing out of the country for investment elsewhere. This ensures that the domestic economy remains stable and that there is enough capital to support both local investments and investments abroad.

Net exports, while related to all of this, are not a direct factor in determining the interest rate in terms of savings and investment. Government spending is a part of the overall economy but does not dictate how the interest rate would adjust in this context either. Thus, the focus on the alignment of domestic investment and net capital outflow explains the proper adjustment of the