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Financial Markets
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Capital Flows
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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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 2
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
The Financial System and the
Allocation 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

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 3
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
The Financial System and the
Allocation of Saving to Productive Uses
The U.S. financial system:
Is a decentralized market oriented system.
 Includes financial institutions and financial
markets.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 4
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
The Financial System and the
Allocation 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

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 5
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
The Financial System and the
Allocation of Saving to Productive Uses
The Banking System

Banks are a financial intermediary between
savers and borrowers.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 6
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
The Financial System and the
Allocation 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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 7
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
The Financial System and the
Allocation 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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 8
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
The Financial System and the
Allocation 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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 9
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
The Financial System and the
Allocation of Saving to Productive Uses
Economic Naturalist

How has the banking crisis in Japan
affected the Japanese economy?
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 10
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
The Financial System and the
Allocation of Saving to Productive Uses
Economic Naturalist

1980s
 Japanese
banks made loans in the bullish real
estate market and acquired stock in
corporations.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 11
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
The Financial System and the
Allocation 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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 12
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
The Financial System and the
Allocation of Saving to Productive Uses
Economic Naturalist
“Credit crunch” occurred and small
businesses could not get loans
 Japan fell into a severe recession

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 13
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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
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Chapter 11: Financial Markets and International
Capital Flows
Slide 14
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
Principal Amount


The Financial System and the
Allocation of Saving to Productive Uses
The amount originally lent
Coupon Rate

The interest rate promised when a bond is
issued
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 15
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
The Financial System and the
Allocation of Saving to Productive Uses
Coupon Payments

Regular interest payments made to the
bondholder
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Chapter 11: Financial Markets and International
Capital Flows
Slide 16
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
The Financial System and the
Allocation 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

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 17
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
The Financial System and the
Allocation 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.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 18
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
The Financial System and the
Allocation 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.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 19
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
The Financial System and the
Allocation of Saving to Productive Uses
Example

Bond prices and interest rates
 Jan
o
o
o
o
Copyright c 2004 by The McGraw-Hill
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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),
assuming she already spent the earlier $50 coupon.
Chapter 11: Financial Markets and International
Capital Flows
Slide 20
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
The Financial System and the
Allocation of Saving to Productive Uses
Example

Bond prices and interest rates
to sell the bond on Jan 1, 2004 (after 1st coupon
payment)
 Want
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
Copyright c 2004 by The McGraw-Hill
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prices and interest rates are inversely related
Chapter 11: Financial Markets and International
Capital Flows
Slide 21
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 22
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 23
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
The Financial System and the
Allocation 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%
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 24
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
The Financial System and the
Allocation 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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 25
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
The Financial System and the
Allocation 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.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 26
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
The Financial System and the
Allocation 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.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 27
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
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?
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 28
MB MC

Bond Markets, Stock Markets,
and the Allocation of Savings
Economic Naturalist

During the 1990s boom:
 Economic
growth fueled expectations of higher
dividends
 Diversification reduced the risk premium
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 29
MB MC

Bond Markets, Stock Markets,
and the Allocation of Savings
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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 30
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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.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 31
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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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 32
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International Capital Flows

International Capital Flows

Purchases or sales of real and financial
assets across international borders
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 33
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 34
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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)
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Chapter 11: Financial Markets and International
Capital Flows
Slide 35
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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
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Chapter 11: Financial Markets and International
Capital Flows
Slide 36
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 37
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 38
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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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 39
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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

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 40
MB MC
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
o U.S. exports = imports or NX = 0 and KI = 0
o NX + KI = 0
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 41
MB MC
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.)
o NX = -$20,000
o Capital inflow = KI = $20,000
o NX (-$20,000) + KI ($20,000) = 0
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 42
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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.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 43
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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
KI > 0
Net capital
inflows
0
Net capital inflow KI
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 44
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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
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Chapter 11: Financial Markets and International
Capital Flows
Slide 45
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An Increase In Risk
Reduces Net Capital Inflows
KI’
Domestic real interest rate r
KI
Increases in risk
reduces the
willingness of foreign
and domestic savers
to hold domestic
assets.
0
Net capital inflow KI
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Chapter 11: Financial Markets and International
Capital Flows
Slide 46
MB MC
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 , or S – I = - KI = NX
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 47
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International Capital Flows

Observation

The pool of saving available for domestic
investment includes national savings and
the funds from savers abroad.
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Chapter 11: Financial Markets and International
Capital Flows
Slide 48
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The Saving-Investment
Diagram For An Open Economy
Real interest rate (%)
S
E
r*
S + KI
• 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
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 49
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The Saving-Investment
Diagram For An Open Economy
Real interest rate (%)
S
E
r*
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
I
Saving and investment
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Chapter 11: Financial Markets and International
Capital Flows
Slide 50
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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.

Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 51
MB MC
International Capital Flows

Economic Naturalist

Why did the Argentine economy collapse
in 2001 - 2002?
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Chapter 11: Financial Markets and International
Capital Flows
Slide 52
MB MC
International Capital Flows

The Saving Rate and the Trade Deficit

A low rate of national saving is the
primary cause of trade deficits.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 53
MB MC
International Capital Flows

The Saving Rate and the Trade Deficit

Y = C + I + G + NX
 Subtracting
C + I + G from both sides
Y - C - I - G = NX
S =Y-C-G
 S - I = NX

 Assuming

I is constant
If S increases, NX increases, and vice
versa.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 54
MB MC
International Capital Flows

The Saving Rate and the Trade Deficit
Low national saving implies high
consumer and government spending
 High rates of spending will:

 Increase
imports.
 Decrease exports.
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 55
MB MC
International Capital Flows

The Saving Rate and the Trade Deficit

Low national saving will also increase
capital inflows.
 High
spending creates investment
opportunities
 Shortage of domestic saving will occur
 Real interest rates will rise
 Capital inflows will occur
Copyright c 2004 by The McGraw-Hill
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Chapter 11: Financial Markets and International
Capital Flows
Slide 56
MB MC
International Capital Flows

Economic Naturalist

Why is the U.S. trade deficit so large?
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Chapter 11: Financial Markets and International
Capital Flows
Slide 57
MB MC
National Saving, Investment, and the
Trade Balance in the U.S., 1960 - 2001
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Chapter 11: Financial Markets and International
Capital Flows
Slide 58
MB MC
International Capital Flows

What Do You Think?

Is the U.S. trade deficit a problem?
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Chapter 11: Financial Markets and International
Capital Flows
Slide 59
End of
Chapter
MB
MC