Aknet Company specializes in the production of small fancy picture frames, which are exported from the U.S. to the United Kingdom. Aknet invoices the exports in pounds and converts the pounds to dollars when they are received. The British demand for these frames is positively related to economic conditions in the United Kingdom. Assume that British inflation and interest rates are similar to the rates in the U.S. Aknet believes that the U.S. balance-of-trade deficit from trade between the U.S. and the United Kingdom will adjust to changing prices between the two countries, while capital flows will adjust to interest rate differentials. Aknet believes that the value of the pound is very sensitive to changing international capital flows, and is moderately sensitive to international trade flows. Aknet is considering the following information:

The U.K. inflation rate is expected to decline, while U.S. inflation rate is expected to rise.

British interest rates are expected to decline, while U.S. interest rates are expected to increase.

c. Aknet believes international capital flows shift in response to changing interest rate differentials. Is there any reason why the changing interest rate differentials in this example will not necessarily cause international capital flows to change significantly? Discuss. [25 Marks]

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