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Financial Markets and International Capital Flows

Financial Markets and International Capital Flows. Introduction. The stock market boom included sound investment decisions and speculation (gambling). The role of financial markets is to ensure national saving is allocated to the most productive uses.

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Financial Markets and International Capital Flows

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  1. Financial Markets and International Capital Flows

  2. Introduction • The stock market boom included sound investment decisions and speculation (gambling). • The role of financial markets is to ensure national saving is allocated to the most productive uses. Chapter 11: Financial Markets and International Capital Flows

  3. The Financial System and theAllocation of Saving to Productive Uses • Key Components of Economic Growth • High rates of saving • An efficient financial system that distributes national savings to the most productive investments Chapter 11: Financial Markets and International Capital Flows

  4. The Financial System and theAllocation of Saving to Productive Uses • The U.S. financial system: • Is a decentralized market oriented system. • Includes financial institutions and financial markets. Chapter 11: Financial Markets and International Capital Flows

  5. The Financial System and theAllocation of Saving to Productive Uses • The financial system in the U.S. improves the allocation of savings in two ways: • Provides information • Helps savers share the risk Chapter 11: Financial Markets and International Capital Flows

  6. The Financial System and theAllocation of Saving to Productive Uses • The Banking System • Banks are a financial intermediary between savers and borrowers. Chapter 11: Financial Markets and International Capital Flows

  7. The Financial System and theAllocation of Saving to Productive Uses • The Banking System • By acting as a financial intermediary, banks can increase the efficiency of the capital market in several ways: • Banks specialize in evaluating the quality of a borrower and perform the task at a lower cost. Chapter 11: Financial Markets and International Capital Flows

  8. The Financial System and theAllocation of Saving to Productive Uses • The Banking System • By acting as a financial intermediary, banks can increase the efficiency of the capital market in several ways: • Banks pool savings, which increases the efficiency of making large loans. Chapter 11: Financial Markets and International Capital Flows

  9. The Financial System and theAllocation of Saving to Productive Uses • The Banking System • By acting as a financial intermediary, banks can increase the efficiency of the capital market in several ways: • Banks develop expertise in making small business and consumer loans. • Banks offer services to savers which attract their deposits. Chapter 11: Financial Markets and International Capital Flows

  10. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • How has the banking crisis in Japan affected the Japanese economy? Chapter 11: Financial Markets and International Capital Flows

  11. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • 1980s • Japanese banks made loans in the bullish real estate market and acquired stock in corporations. Chapter 11: Financial Markets and International Capital Flows

  12. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • 1990s • Real estate prices plummeted and many borrowers defaulted on their loans. • Falling stock prices reduced the value of the banks’ shareholdings Chapter 11: Financial Markets and International Capital Flows

  13. The Financial System and theAllocation of Saving to Productive Uses • Economic Naturalist • “Credit crunch” occurred and small businesses could not get loans • Japan fell into a severe recession Chapter 11: Financial Markets and International Capital Flows

  14. The Financial System and theAllocation of Saving to Productive Uses • Bond • A legal promise to repay a debt, usually including both the principal amount and regular interest payments Chapter 11: Financial Markets and International Capital Flows

  15. The Financial System and theAllocation of Saving to Productive Uses • Principal Amount • The amount originally lent • Coupon Rate • The interest rate promised when a bond is issued Chapter 11: Financial Markets and International Capital Flows

  16. The Financial System and theAllocation of Saving to Productive Uses • Coupon Payments • Regular interest payments made to the bondholder Chapter 11: Financial Markets and International Capital Flows

  17. The Financial System and theAllocation of Saving to Productive Uses • Bonds -- An Example • Principle amount of a bond = $1,000,000 • Coupon rate = 5% • Annual coupon payment = (0.05)($1,000,000) = $50,000 Chapter 11: Financial Markets and International Capital Flows

  18. The Financial System and theAllocation of Saving to Productive Uses • Bonds • Corporations and governments sell bonds to raise funds. • The longer the term of the bond the higher the coupon rate. Chapter 11: Financial Markets and International Capital Flows

  19. The Financial System and theAllocation of Saving to Productive Uses • Bonds • The greater the risk of default, the higher the coupon rate. • Municipal bonds are exempt from federal taxes and have a lower coupon rate. • Bondholders may sell their bonds at any time in the bond market at their market price. Chapter 11: Financial Markets and International Capital Flows

  20. The Financial System and theAllocation of Saving to Productive Uses • Example • Bond prices and interest rates • Jan 1, 2003 purchase a 2 year government bond • Principle amount = $1,000 • Coupon rate = 0.05 • Coupon payment = $1,000 x 0.05 = $50 (Jan 1, 2004) • At maturity: $1,000 + $50 = $1,050 (Jan 1, 2005) Chapter 11: Financial Markets and International Capital Flows

  21. The Financial System and theAllocation of Saving to Productive Uses • Example • Bond prices and interest rates • Want to sell the bond on Jan 1, 2004 The prevailing interest rate = 6% Bond price x 1.06 = $1,050 Bond price = $1,050/1.06 = $991 The prevailing interest rate = 4% Bond price = $1,050/1.04 = $1,010 • Observation • Bond prices and interest rates are inversely related Chapter 11: Financial Markets and International Capital Flows

  22. The Financial System and theAllocation of Saving to Productive Uses • Stock (or equity) • A claim to partial ownership of a firm Chapter 11: Financial Markets and International Capital Flows

  23. The Financial System and theAllocation of Saving to Productive Uses • Two sources of return to stockholders • Dividend • A regular payment received by stockholders for each share that they own • Capital gain • The difference between the purchase price and selling price, when the selling price is higher Chapter 11: Financial Markets and International Capital Flows

  24. The Financial System and theAllocation of Saving to Productive Uses • Example • How much should you pay for a share of FortuneCookie.com • Dividend = $1.00/share in one year • Price/share = $80 in one year • Each share will be worth $81 in one year • Rate of return = 6% Chapter 11: Financial Markets and International Capital Flows

  25. The Financial System and theAllocation of Saving to Productive Uses • Example • How much should you pay for a share of FortuneCookie.com • Stock price x 1.06 = $81 • Stock price = $81/1.06 = $76.42 • If dividend = $5, stock price = $85/1.06 = $80.19 Chapter 11: Financial Markets and International Capital Flows

  26. The Financial System and theAllocation of Saving to Productive Uses • Observations • An increase in future dividends or future stock prices will raise the price of the stock today. • An increase in required rate of return will lower today’s stock price. Chapter 11: Financial Markets and International Capital Flows

  27. The Financial System and theAllocation of Saving to Productive Uses • Observations • The uncertainty of future earnings and dividends increases the risk of purchasing a stock. • Stock market investors account for this risk by requiring a higher rate of return or risk premium. Chapter 11: Financial Markets and International Capital Flows

  28. Bond Markets, Stock Markets, and the Allocation of Savings • Economic Naturalist • Why did the U.S. stock market rise sharply in the 1990s, then fall in the new millennium? Chapter 11: Financial Markets and International Capital Flows

  29. Economic Naturalist During the 1990s boom: Economic growth fueled expectations of higher dividends Diversification reduced the risk premium Bond Markets, Stock Markets, and the Allocation of Savings Chapter 11: Financial Markets and International Capital Flows

  30. Economic Naturalist The millennium decline Tech failures and scandals lowered the dividend expectations. Risk premium rose in response to the recession, terrorist attacks, and corporate scandals. Bond Markets, Stock Markets, and the Allocation of Savings Chapter 11: Financial Markets and International Capital Flows

  31. International Capital Flows • Two Macroeconomic Roles for International Capital Flows • A country with greater investment opportunities than savings can fill the savings gap by borrowing from abroad. • International capital flows allow countries to run trade imbalances. Chapter 11: Financial Markets and International Capital Flows

  32. International Capital Flows • International financial markets allocate savings to productive capital in different countries. • International financial markets are subject to the laws of at least two countries. Chapter 11: Financial Markets and International Capital Flows

  33. International Capital Flows • International Capital Flows • Purchases or sales of real and financial assets across international borders Chapter 11: Financial Markets and International Capital Flows

  34. International Capital Flows • Capital Inflows • Purchases of domestic assets by foreign households and firms • Capital Outflows • Purchases of foreign assets by domestic households and firms Chapter 11: Financial Markets and International Capital Flows

  35. International Capital Flows • Trade Balance (or net exports) • The value of a country’s exports less the value of its imports in a particular period (quarter or year) Chapter 11: Financial Markets and International Capital Flows

  36. International Capital Flows • Trade Surplus • When exports exceed imports, the difference between the value of a country’s exports and the value of its imports in a given period Chapter 11: Financial Markets and International Capital Flows

  37. International Capital Flows • Trade Deficit • When imports exceed exports, the difference between the value of a country’s imports and the value of its exports in a given period Chapter 11: Financial Markets and International Capital Flows

  38. The U.S. TradeBalance, 1960 - 2001 • Observations • Trade has become increasingly important • Since the 1970s, the U.S. has run trade deficits Chapter 11: Financial Markets and International Capital Flows

  39. International Capital Flows • Trade balance • Difference between the value of goods and services exported and imported • Net Capital Flows • Difference between purchases of domestic assets by foreigners and the purchase of foreign assets by domestic residents Chapter 11: Financial Markets and International Capital Flows

  40. International Capital Flows • Capital Flows and the Balance of Trade • NX = trade balance (net exports) • KI = net capital inflows • NX + KI = 0 Chapter 11: Financial Markets and International Capital Flows

  41. International Capital Flows • Understanding NX + KI = 0 • U.S. resident buys a $20,000 Japanese automobile • The Japanese car manufacturer receives $20,000 and has two options • He can buy $20,000 of U.S. goods • U.S. exports = imports or NX = 0 and KI = 0 • NX + KI = 0 Chapter 11: Financial Markets and International Capital Flows

  42. International Capital Flows • Understanding NX + KI = 0 • U.S. resident buys $20,000 Japanese automobile • The Japanese car manufacturer has $20,000 and has two options • He can buy U.S. assets (land, bond, etc.) • NX = -$20,000 • Capital inflow = KI = $20,000 • NX (-$20,000) + KI ($20,000) = 0 Chapter 11: Financial Markets and International Capital Flows

  43. International Capital Flows • The Determinants of International Capital Flows • Real interest rate • High domestic real interest rates will cause net capital inflows. • Low domestic real interest rates will cause net capital outflows. Chapter 11: Financial Markets and International Capital Flows

  44. Net capital inflows, KI KI < 0 Net capital outflows KI > 0 Net capital inflows 0 Net Capital Inflows and The Real Interest Rate Domestic real interest rate r Net capital inflow KI Chapter 11: Financial Markets and International Capital Flows

  45. International Capital Flows • Risk • For a given real interest rate, an increase in riskiness in domestic assets will reduce net capital inflows and vice versa Chapter 11: Financial Markets and International Capital Flows

  46. KI’ Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets. An Increase In Risk Reduces Net Capital Inflows KI Domestic real interest rate r 0 Net capital inflow KI Chapter 11: Financial Markets and International Capital Flows

  47. International Capital Flows • Saving, Investment, and Capital Inflows • Y = C + I + G + NX • Subtract C + G + NX from both sides • Y - C - G - NX = I • National saving (S) = Y - C - G • NX + KI = 0; so, KI = -NX • Substitute S for Y - C - G & KI for -NX • S + KI = I Chapter 11: Financial Markets and International Capital Flows

  48. International Capital Flows • Observation • The pool of saving available for domestic investment includes national savings and the funds from savers abroad. Chapter 11: Financial Markets and International Capital Flows

  49. S S + KI • I = demand for capital investment funds • S + KI = total supply of saving • S = domestic supply of saving • R* = equilibrium real interest rate E r* I The Saving-Investment Diagram For An Open Economy Real interest rate (%) Saving and investment Chapter 11: Financial Markets and International Capital Flows

  50. S S + KI • Observations • For high r, KI are positive and S + KI is to the right of S • For low r, KI are negative and S + KI is to the left of S • At low r, net saving is reduced in an open economy E r* I The Saving-Investment Diagram For An Open Economy Real interest rate (%) Saving and investment Chapter 11: Financial Markets and International Capital Flows

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