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Financial Markets
and International
Capital Flows
Principles of Macroeconomics
Dr. Gabriel X. Martinez
Ave Maria University
The Dow Jones Industrial Average 1994-2003
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Chapter 24: Financial Markets and
International Capital Flows
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The Dow Jones Industrial Average 2003-2006
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Chapter 24: Financial Markets and
International Capital Flows
6
The Dow Jones Industrial Average 1986-1989
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Chapter 24: Financial Markets and
International Capital Flows
7
The Financial System and the
Allocation of Saving to Productive Uses
 The role of financial markets is to ensure
national saving is allocated to the most
productive uses.
 Key Components of Economic Growth
 High rates of saving
 An efficient financial system that distributes
national savings to the most productive
investments
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Chapter 24: Financial Markets and
International Capital Flows
8
The Financial System and the
Allocation of Saving to Productive Uses
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Chapter 24: Financial Markets and
International Capital Flows
9
The Financial System and the
Allocation of Saving to Unproductive Uses
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Chapter 24: Financial Markets and
International Capital Flows
10
The Financial System and the
Allocation of Saving to Productive Uses
 Most rich countries’ financial systems:
 Decentralized, market-oriented system.
 Include financial institutions and financial
markets.
 Financial systems malfunction in most poor
countries.
 Government interference or conflicts of interest
 Inefficient institutions and weak markets
This is an important topic for
Economic Development, Chapter 24: Financial Markets and
ECOc 320
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International Capital Flows
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The Financial System and the
Allocation of Saving to Productive Uses
 High rates of saving and capital formation
are important for economic growth and
increased productivity…
 … but they are not enough.
 “A successful economy not only saves but
also uses its savings wisely by applying
these limited funds to the investment
projects that seem likely to be the most
productive.”
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Chapter 24: Financial Markets and
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12
The Financial System and the
Allocation of Saving to Productive Uses
 The Banking System
 Banks are a financial intermediary between
savers and borrowers.
 Other financial intermediaries are Savings and
Loans, Credit Unions, Mutual Funds, etc.
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Chapter 24: Financial Markets and
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The Financial System and the
Allocation of Saving to Productive Uses
 The Banking System
 Banks specialize in evaluating the quality of a
borrower and perform the task at a lower cost.
 Banks develop expertise in making small business
and consumer loans.
 Banks pool savings, which increases the
efficiency of making large loans.
 Banks offer services to savers which attract their
deposits.
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Chapter 24: Financial Markets and
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The Financial System and the
Allocation of Saving to Productive Uses
 Bond
 A legal promise to repay a debt, usually
including both the principal amount and regular
interest payments.
Source:
www.rainfall.com/
posters/WWI/catalog
11.htm
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Chapter 24: Financial Markets and
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The Financial System and the
Allocation of Saving to Productive Uses
 Bonds
 Corporations and governments sell bonds to
raise funds.
 Bonds have to pay higher interest rates if:
• They repay the principal farther into the future;
• They are more difficult to resell to other people;
• They are more likely to not be paid back.
This is an important topic for Banking,
Money, and Finance, ECO 342
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Chapter 24: Financial Markets and
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The Financial System and the
Allocation of Saving to Productive Uses
 Stock (or equity)
 A claim to partial ownership of a firm
A share
of stock
in the
Titanic
Source:
www.pomexp
ort.com/
O%20%20Titanic%2
0Stock%20C..
.
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The Financial System and the
Allocation 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.
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The Financial System and the
Allocation of Saving to Productive Uses
 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.
i
 US stock market
Risk
Dividends
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Chapter 24: Financial Markets and
International Capital Flows
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Extra Credit
 From some sections of Chapter 21 (The Labor
Market) and of Chapter 24 (The Financial Market):
 Study pp. 535 – 553.
 Answer Questions 2 and 5; and Problems 2, 3, and 4
(pp. 560-561)
 Study pp. 617 – 627.
 Answer Questions 1, 2, and 3; and Problems 2 and 3
(pp. 638-639).
 Turn in your work before Monday, December 12.
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Chapter 24: Financial Markets and
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32
International Capital Flows
International Capital Flows
 Two Macroeconomic Roles for
International Capital Flows
 Suppose a country has great investment
opportunities, but very low savings.
 The country can fill the “savings gap” by
borrowing from abroad.
 “Borrowing from abroad” is an international capital
flow.
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International Capital Flows
 Two Macroeconomic Roles for International
Capital Flows
 International capital flows allow countries to run trade
imbalances.
 To pay for Imports > Exports.
 In September 2005, the US sold goods and services worth
$105 billion to foreign countries.
 But it bought goods and services worth $171 billion from
abroad.
 It paid for this imbalance by borrowing from abroad and
selling assets to foreigners..
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Chapter 24: Financial Markets and
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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.
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Chapter 24: Financial Markets and
International Capital Flows
36
The Financial System and the
Allocation of Saving to Productive Uses
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Chapter 24: Financial Markets and
International Capital Flows
37
The Financial System and the
Allocation of Saving to Productive Uses
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Chapter 24: Financial Markets and
International Capital Flows
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International Capital Flows
 International Capital Flows
 Purchases or sales of real and financial
assets across international borders.
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Chapter 24: Financial Markets and
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International Capital Flows
 International Capital Flows
 If a Japanese
 person buys Ford Co. stock…
 corporation buys Rockefeller Center …
 corporation builds a plant in Kentucky …
 insurance company deposits funds in
a US bank …
 … Then you have a international capital flow.
This is the basic subject of
International Monetary Economics, ECO 421
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Chapter 24: Financial Markets and
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International Capital Flows
 International Capital Flows are Flows
 Not stocks.
 We measure capital flows over a period of
time.
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Chapter 24: Financial Markets and
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International Capital Flows
 Capital Inflows
 Purchases of domestic assets by foreign
households and firms.
Home
Foreign
 Capital Outflows
 Purchases of foreign assets by domestic
households and firms.
Home
Foreign
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International Capital Flows
 Trade Balance (or Net Exports)
 The value of a country’s exports of goods and
services less the value of its imports of goods
and services in a particular period (quarter or
year).
 NX = X – IM
 It excludes the payment of interest on debt.
 NX + Interest = Current Account
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Chapter 24: Financial Markets and
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The U.S. Trade
Balance, 1960 - 2001
Observations
•Trade has become increasingly important
•Since the 1970s, the U.S. has run trade deficits
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Chapter 24: Financial Markets and
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International Capital Flows
 Trade Surplus, NX > 0
 Exports exceed imports.
 How do foreigners pay for all the extra imports
they buy?
 Trade Deficit , NX < 0
 Imports exceed exports.
 If we buy more than we sell, how do we pay
for it?
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NX + KI = 0
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International Capital Flows
 Net Capital Flows
 Difference between purchases of domestic
assets by foreigners and the purchase of
foreign assets by domestic residents.
 Trade balance
 Difference between the value of goods and
services exported and imported.
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Chapter 24: Financial Markets and
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International Capital Flows
 Capital Flows and the Balance of Trade
 NX = trade balance (net exports)
 KI = net capital inflows
NX + KI = 0
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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 three options
 He can buy $20,000 of U.S. goods
 He can buy U.S. assets (land, bond, etc.)
 He can put the $20,000 in a bank. The bank will
lend them to someone, and that someone will buy
either US goods or US assets.
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International Capital Flows
 Understanding NX + KI = 0
 American spends $20,000 on Japanese car.
 If Japanese people buy $20,000 of U.S.
goods
 So U.S. exports = imports  NX = 0. Also, KI = 0
 NX + KI = 0
 If Japanese people buy U.S. assets (land,
bond, etc.)
 US NX = – $20,000
 US Capital inflow = KI = $20,000
 NX (-$20,000) + KI ($20,000) = 0
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Chapter 24: Financial Markets and
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International Capital Flows
 Understanding NX + KI = 0
 American spends $20,000 on Japanese car.
 If Japanese people put the $20,000 in a US
bank.
 US Bank deposits are US assets.
 US NX = – $20,000
 US Capital inflow = KI = $20,000
 NX (-$20,000) + KI ($20,000) = 0
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Chapter 24: Financial Markets and
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International Capital Flows
The Determinants of International
Capital Flows
International Capital Flows
 The Determinants of International Capital
Flows
 Real interest rate
 High domestic real interest rates will cause net
capital inflows.
• Why?
 Low domestic real interest rates will cause net
capital outflows.
• Why?
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Chapter 24: Financial Markets and
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International Capital Flows
 The Determinants of International Capital
Flows
 Real interest rate
 Suppose that in 2005 Japanese bonds have a 5%
return and US bonds have a 5% return.
 If US interest rates drop in 2006 to 4%, whose
bonds should you buy?
• This a K outflow for the US
 If US interest rates rise in 2007 to 7%, whose
bonds should you buy?
• This a K inflow for the US
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Chapter 24: Financial Markets and
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Domestic real interest rate r
Net Capital Inflows
and The Real Interest Rate
If r>r*, KI > 0
World interest
rate, r*
If r<r*, KI < 0
0
Net capital inflow KI
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Chapter 24: Financial Markets and
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Net Capital Inflows
and The Real Interest Rate
Domestic real interest rate r
Net capital inflows, KI
KI < 0
Net capital
outflows
World interest
rate, r*
KI > 0
Net capital
inflows
0
Net capital inflow KI
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Chapter 24: Financial Markets and
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56
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.
 Suppose there is a political revolution in the
country; (K out)
 Or that the government defaults on its debts; (K
out)
 Or that a new government is closely allied with
international financial organizations; (K in)
 Or that GDP rises for that country. (K in)
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An Increase In Risk
Reduces Net Capital Inflows
KI’
Domestic real interest rate
r
KI
Increases in risk
reduce the willingness
of foreign and
domestic savers to
hold domestic assets.
0
Net capital inflow
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KI
Chapter 24: Financial Markets and
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58
International Capital Flows
Saving, Investment, and Capital
Inflows
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
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International Capital Flows
Y - C - G - NX = I
National saving (S) = Y - C - G
- NX
= KI
Because NX + KI = 0
S + KI = I
 Investment needs can be financed by national
saving and by capital inflows.
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In equilibrium
Quantity Saved = Quantity
Invested
S + KI = I
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The Saving-Investment
Diagram For An Open Economy
Real interest rate (%)
S
If the economy is closed
r*
E
• I = demand for capital
investment funds
• S = domestic supply of saving
• r* = equilibrium real interest
rate
I
Saving and investment
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Chapter 24: Financial Markets and
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63
The Saving-Investment
Diagram For An Open Economy
Real interest rate (%)
S
S + KI
If the economy is open
E
r*
• I = demand for capital
investment funds
• S + KI = total supply of saving
• S = domestic supply of saving
• r* = equilibrium real interest
rate
I
Saving and investment
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Chapter 24: Financial Markets and
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64
International Capital Flows
 Observations
 A country that attracts foreign capital will have
lower real interest and higher investment.
 Countries with a stable political environment
and well defined property rights will attract
more foreign capital.
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Chapter 24: Financial Markets and
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65
The Saving-Investment
Diagram For An Open Economy
Real interest rate (%)
S
S + KI
E
r*
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
I
Saving and investment
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Chapter 24: Financial Markets and
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66
The Saving-Investment
Diagram For An Open Economy
S + KI
Real interest rate (%)
S’ + KI
• If the government
moves to a surplus,
National Saving
rises at every level
of the interest rate.
• The I curve is
downward sloping,
so interest rates fall
and quantity
invested rises.
E
r*
r*’
E’
I
Saving and investment
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Chapter 24: Financial Markets and
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67
The Saving-Investment
Diagram For An Open Economy
S + KI
Real interest rate (%)
S + KI’
• If the country
experiences a
decrease in the level
of risk, capital flows
in.
• The I curve is
downward sloping,
so interest rates fall
and quantity
invested rises.
E
r*
r*’
E’
I
Saving and investment
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Chapter 24: Financial Markets and
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70
International Capital Flows
 The Saving Rate and the Trade Deficit
 Low rates of national saving or very high
investment rates are the primary causes of
trade deficits.
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International Capital Flows
 The Saving Rate and the Trade Deficit
 Before, we found that
S + KI = I
 Recall that NX = - KI. Rearrange to show
S - I = NX
 Assuming I is constant,
 If S decreases, NX decreases, and vice versa.
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International Capital Flows
 The Saving Rate and the Trade Deficit
 Low national saving are often due to high
consumer and government spending
 High rates of spending will:
 Increase imports.
• If people consume more, or firms demand more capital
goods, they will demand foreign consumption/capital
goods.
 Decrease exports.
• If people consume more, or firms demand more capital
goods, some consumption/capital goods that would have
been exported will be purchased domestically.
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International Capital Flows
 The Saving Rate and the Trade Deficit
 Suppose there are abundant investment
opportunities (maybe because the country is
underdeveloped and most needs are still
unmet).
 Think of the American West.
 Often, there’s little saving, so a shortage of
domestic saving (S>I) will occur.
 Real interest rates will rise.
 Capital will flow in.
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International Capital Flows
 Economic Naturalist
 Why is the U.S. trade deficit so large?
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Chapter 24: Financial Markets and
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75
National Saving, Investment, and the
Trade Balance in the U.S., 1960 – 2006
25%
20%
15%
10%
5%
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
Jan-73
Jan-71
Jan-69
Jan-67
Jan-65
Jan-63
Jan-61
Jan-59
0%
-5%
-10%
Gross Saving
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Domestic Investment/GDP
ChapterGross
24:Private
Financial
Markets and
International Capital Flows
Current Account/GDP
76
What have we learned today
 The financial market is complex but
essential.
 It is “the circulatory system” of an economy
because it puts wealth in the hands of
people who can use it productively.
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Chapter 24: Financial Markets and
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What have we learned today
 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.
 They help finance investment opportunities
when savings are low.
 They help pay for imports when exports are low.
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What have we learned today
 International capital flows, KI
 Trade Balance = NX = X – IM
 NX + KI = 0
 Determinants of Capital Inflows
 High domestic real interest rates will cause net
capital inflows.
 Increases in the level of risk of the domestic
economy will reduce KI.
• Increases in foreign real interest rates will cause outflows.
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Chapter 24: Financial Markets and
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What have we learned today
 International capital flows, KI
 In equilibrium, Quantity Saved = Quantity
Invested
 S + KI = I
S + KI
r
E
I
Saving and investment
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Chapter 24: Financial Markets and
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What have we learned today
 International capital flows, KI
 Low rates of domestic saving increase interest
rates, which attract capital inflows.
 High rates of investment
S + KI
raise r and capital inflows.
 Increases in country risk r
E
reduce KI, forcing r up
and reducing investment.
I
Saving and investment
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Chapter 24: Financial Markets and
International Capital Flows
81