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Financial Markets and International Capital Flows MB MC MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 2 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 3 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 4 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 5 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 6 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 7 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 8 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 9 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 10 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 11 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 12 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 13 MB MC 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 14 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 15 MB MC The Financial System and the Allocation of Saving to Productive Uses Coupon Payments Regular interest payments made to the bondholder Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 16 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 17 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 18 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 19 MB MC 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 Companies, Inc. All rights reserved. 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 MB MC 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 Companies, Inc. All rights reserved. prices and interest rates are inversely related Chapter 11: Financial Markets and International Capital Flows Slide 21 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 22 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 23 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 24 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 25 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 26 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 27 MB MC 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 30 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 31 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 32 MB MC International Capital Flows International Capital Flows Purchases or sales of real and financial assets across international borders Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 33 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 34 MB MC 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) Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 35 MB MC 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 36 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 37 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 38 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 39 MB MC 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 42 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 43 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 44 MB MC 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 45 MB MC 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 47 MB MC International Capital Flows Observation The pool of saving available for domestic investment includes national savings and the funds from savers abroad. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 48 MB MC 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 Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 49 MB MC 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 50 MB MC 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 Companies, Inc. All rights reserved. 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? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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 Companies, Inc. All rights reserved. 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? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 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? Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 59 End of Chapter MB MC