1 Frank & Bernanke 3 rd edition, 2007 Ch. 11: Financial Markets and International Capital Flows

2 Savings and Investments National savings done by governments, households and businesses will not be channeled into investments if there is no intermediary to bring the two sides together. National savings done by governments, households and businesses will not be channeled into investments if there is no intermediary to bring the two sides together. Even if there were intermediaries, investments may not be productive and resources may be wasted, condemning the future generations to poverty. Even if there were intermediaries, investments may not be productive and resources may be wasted, condemning the future generations to poverty.

3 Savings Lack of options for households may force them to keep their wealth in money form. Lack of options for households may force them to keep their wealth in money form. A relatively high inflation would wipe out most of their wealth. A relatively high inflation would wipe out most of their wealth. In many poor countries, households keep their wealth in gold. In many poor countries, households keep their wealth in gold. In , gold prices reached $800/oz.. 2/24/2004: $403.45/oz. 3/8/2005: $438.88/oz. 2/13/2007: $ In , gold prices reached $800/oz.. 2/24/2004: $403.45/oz. 3/8/2005: $438.88/oz. 2/13/2007: $ A financial system that can provide trust and security to small savers can increase the amount of savings in a poor country. A financial system that can provide trust and security to small savers can increase the amount of savings in a poor country.

4 Investments Those that need funds to bring new products or to expand operations (entrepreneurs and managers) are taking risks. They do not know what the future will hold but given their present day knowledge they are betting on a positive outcome. Those that need funds to bring new products or to expand operations (entrepreneurs and managers) are taking risks. They do not know what the future will hold but given their present day knowledge they are betting on a positive outcome. If all investments are done through a central office, an unfortunate turn of events can render the investment worthless and savings wasted. If all investments are done through a central office, an unfortunate turn of events can render the investment worthless and savings wasted. Concentration of risk, political decision-making, limited knowledge can waste scarce resources and render investments unproductive. Concentration of risk, political decision-making, limited knowledge can waste scarce resources and render investments unproductive.

5 Financial System A well-developed financial system provides many alternatives for savers. A well-developed financial system provides many alternatives for savers. Different risk levels; different size levels; different maturities; different liquidity levels. Different risk levels; different size levels; different maturities; different liquidity levels. A well-developed financial system provides scarce and costly information for lenders, thus reducing the overall risk. A well-developed financial system provides scarce and costly information for lenders, thus reducing the overall risk. A well-developed financial system channels savings to most productive use. A well-developed financial system channels savings to most productive use.

6 Financial Institutions What if someone comes and gives a brilliant talk on how she can make you a millionaire if you only gave her $100,000? What if someone comes and gives a brilliant talk on how she can make you a millionaire if you only gave her $100,000? Can someone with savings of $1000 have the means to investigate the validity of high rate of returns promised? Can someone with savings of $1000 have the means to investigate the validity of high rate of returns promised? What if special skills and knowledge is required to evaluate claims. What if special skills and knowledge is required to evaluate claims.

7 Financial Institutions Asymmetric information creates a need for specialized institutions to evaluate risk. Asymmetric information creates a need for specialized institutions to evaluate risk. Comparative advantage leads to specialization. Comparative advantage leads to specialization. Economies of scale allows financial institutions to collect information and to channel savings into loans at low cost. Economies of scale allows financial institutions to collect information and to channel savings into loans at low cost.

8 Banking Crisis and Japanese Recession 1980s: Japanese banks made loans in the bullish real estate market and acquired stock in corporations. 1980s: Japanese banks made loans in the bullish real estate market and acquired stock in corporations. 1990s 1990s Real estate prices plummeted and many borrowers defaulted on their loans. Real estate prices plummeted and many borrowers defaulted on their loans. Falling stock prices reduced the value of the banks’ shareholdings Falling stock prices reduced the value of the banks’ shareholdings “Credit crunch” occurred and small businesses could not get loans “Credit crunch” occurred and small businesses could not get loans Japan fell into a severe recession Japan fell into a severe recession

9 Bonds A bond is an IOU that indicates the principal to be paid at maturity (face value), the rate of interest to be earned per year on the principal (coupon rate), and the date the bond will mature (date the principal will be paid). A bond is an IOU that indicates the principal to be paid at maturity (face value), the rate of interest to be earned per year on the principal (coupon rate), and the date the bond will mature (date the principal will be paid). Bonds are issued by borrowers and bought by lenders. Bonds are issued by borrowers and bought by lenders. During the life of the bond, the holders may decide to sell the bond to someone else. During the life of the bond, the holders may decide to sell the bond to someone else.

10 Bonds Bonds issued by different entities carry different coupon rates. Credit risk is the most important reason that determines the variations in coupon rates in same maturity bonds. Bonds issued by different entities carry different coupon rates. Credit risk is the most important reason that determines the variations in coupon rates in same maturity bonds. Municipal bonds usually have lower coupon rates because they are exempt from federal taxation. Municipal bonds usually have lower coupon rates because they are exempt from federal taxation.

11 Bonds Joe buys a 2-year government bond (Treasury note) issued on Jan. 1, 2007 with a face-value of $1,000 and a coupon rate of 4%. Joe buys a 2-year government bond (Treasury note) issued on Jan. 1, 2007 with a face-value of $1,000 and a coupon rate of 4%. Who is the lender and who is the borrower? Who is the lender and who is the borrower? On Jan. 1, 2008 and on Jan. 1, 2009 how much will the government pay to the holder of this bond? On Jan. 1, 2008 and on Jan. 1, 2009 how much will the government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2008, what price does he expect to get for his bond if If Joe wants to sell his bond on Jan. 2, 2008, what price does he expect to get for his bond if similar bonds pay an interest rate of 4%? similar bonds pay an interest rate of 4%? similar bonds pay an interest rate of 3%? similar bonds pay an interest rate of 3%? similar bonds pay an interest rate of 5%? similar bonds pay an interest rate of 5%?

12 Bond Prices and Interest Rates When interest rates rise, bond prices fall. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. When interest rates fall, bond prices rise. If Lydia expects to see higher interest rates in the future, should she buy or sell bonds today? (Hint: think about capital gains and losses). If Lydia expects to see higher interest rates in the future, should she buy or sell bonds today? (Hint: think about capital gains and losses).

13 Stocks Stocks are shares in the ownership of a public company. Stocks are shares in the ownership of a public company. Stockholders are paid dividends from the profits of the company. Stockholders are paid dividends from the profits of the company. If future profits are expected to increase, dividends are expected to increase, creating an extra demand for the stock and pushing the price of the stock up today. If future profits are expected to increase, dividends are expected to increase, creating an extra demand for the stock and pushing the price of the stock up today.

14 Stocks When a company issues stock it receives the funds to use for expansion, investment. When a company issues stock it receives the funds to use for expansion, investment. When existing stocks are bought and sold in the stock market, the company gets nothing except a signal that if it wants to raise funds would it be cheaper or more expensive. When existing stocks are bought and sold in the stock market, the company gets nothing except a signal that if it wants to raise funds would it be cheaper or more expensive. Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond prices also reduces the stock prices. Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond prices also reduces the stock prices.

15 Stock Prices Suppose you expect the stock price of IBM to be $100 a year from now and also you expect dividends per share to be $5, then. Suppose you expect the stock price of IBM to be $100 a year from now and also you expect dividends per share to be $5, then. Assuming that given the riskiness of IBM, you desire to have a return of 8% on your savings, what price are you willing to pay for this stock? Assuming that given the riskiness of IBM, you desire to have a return of 8% on your savings, what price are you willing to pay for this stock? Hint: If you were to sell the stock a year from now, how much would you get and what is the present value today that will yield 8% to bring this amount? Hint: If you were to sell the stock a year from now, how much would you get and what is the present value today that will yield 8% to bring this amount? P (1.08) = $105 P (1.08) = $105 P = $105/1.08 = $97.22 P = $105/1.08 = $97.22

16 Stock Prices If in general, interest rates have risen because of inflation, so that you expect 10% return rather than 8%, how much would you pay for the same IBM stock? If in general, interest rates have risen because of inflation, so that you expect 10% return rather than 8%, how much would you pay for the same IBM stock? P = $105/1.1 = $95.45 P = $105/1.1 = $95.45 What if you expected IBM price to be $110? What if you expected IBM price to be $110? What if you expected dividends to be $10? What if you expected dividends to be $10?

17 Stock Prices Observations Observations An increase in future dividends or future stock prices will raise the price of the stock today. 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. An increase in required rate of return will lower today’s stock price. The uncertainty of future earnings and dividends increases the risk of purchasing a stock. 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. Stock market investors account for this risk by requiring a higher rate of return or risk premium.

18 U.S. Stock Market During the 1990s boom: During the 1990s boom: Economic growth fueled expectations of higher dividends Economic growth fueled expectations of higher dividends Diversification reduced the risk premium Diversification reduced the risk premium The millennium decline The millennium decline Tech failures and scandals lowered the dividend expectations. Tech failures and scandals lowered the dividend expectations. Risk premium rose in response to the recession, terrorist attacks, and corporate scandals. Risk premium rose in response to the recession, terrorist attacks, and corporate scandals.

19 Newly Issued Stocks and Bonds In order to raise funds (to borrow) businesses can go to the banks or issue new stocks or bonds. In order to raise funds (to borrow) businesses can go to the banks or issue new stocks or bonds. If the future of the business is considered risky, the bonds will carry a high interest rate and the stocks will sell at a low price. If the future of the business is considered risky, the bonds will carry a high interest rate and the stocks will sell at a low price.

20 Three Classes of Assets Bonds Bonds Stocks Stocks Money Money They all respond to interest rates. They all respond to interest rates. The higher the interest rate, the lower is the quantity of bonds and stocks supplied. The higher the interest rate, the lower is the quantity of bonds and stocks supplied. The higher the interest rates, the lower is the quantity of money demanded. The higher the interest rates, the lower is the quantity of money demanded.

21 Information and Risk Stock and bond markets allocate scarce savings to the best (highest return) users building on the information available. Stock and bond markets allocate scarce savings to the best (highest return) users building on the information available. Riskiness shies the savers away; diversification reduces riskiness. Riskiness shies the savers away; diversification reduces riskiness.

22 International Capital Flows Purchases of foreign real or financial assets are capital outflows. Purchases of foreign real or financial assets are capital outflows. Sales of real or financial assets to foreigners are capital inflows. Sales of real or financial assets to foreigners are capital inflows. Capital inflows allows the country as a whole to import more than it exports. Capital inflows allows the country as a whole to import more than it exports. Trade surplus (NX>0) allows the residents of surplus country to accumulate assets in another country. Trade surplus (NX>0) allows the residents of surplus country to accumulate assets in another country.

23 International Capital Flows Trade surplus: capital outflow Trade surplus: capital outflow Trade deficit: capital inflow. Trade deficit: capital inflow. KI = -NX KI = -NX NX = -KI (capital outflow) NX = -KI (capital outflow) NX + KI = 0 NX + KI = 0

24 Savings Y = C + I + G + NX Y = C + S p + T S p + T = I + G + NX S p + (T – G) – NX = I Private sector savings + Government sector savings + Trade deficit = Investments National savings + Capital inflow = Investments S p + (T – G) = S - NX = KI National savings = Investments + Capital outflow S = I + NX

25 Understanding NX + KI = 0 U.S. resident buys a $20,000 Japanese car U.S. resident buys a $20,000 Japanese car The Japanese car manufacturer receives $20,000 and has two options The Japanese car manufacturer receives $20,000 and has two options He can buy $20,000 of U.S. goods He can buy $20,000 of U.S. goods U.S. exports = imports or NX = 0 and KI = 0 U.S. exports = imports or NX = 0 and KI = 0 NX + KI = 0 NX + KI = 0 He can buy U.S. assets (land, bond, etc.) He can buy U.S. assets (land, bond, etc.) NX = -$20,000 NX = -$20,000 Capital inflow = KI = $20,000 Capital inflow = KI = $20,000 NX (-$20,000) + KI ($20,000) = 0 NX (-$20,000) + KI ($20,000) = 0

26 The U.S. Trade Balance

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28 International Capital Flows Trade balance Trade balance Difference between the value of goods and services exported and imported Difference between the value of goods and services exported and imported Net Capital Flows Net Capital Flows Difference between purchases of domestic assets by foreigners and the purchase of foreign assets by domestic residents Difference between purchases of domestic assets by foreigners and the purchase of foreign assets by domestic residents

29 What Determines Capital Flows Return (real interest rates in different countries) Return (real interest rates in different countries) Risk (riskiness of domestic assets increases => both locals and foreigners shy away from domestic assets) Risk (riskiness of domestic assets increases => both locals and foreigners shy away from domestic assets)

30 Explain Using the definitional equations, explain the chronic US trade deficit. Using the definitional equations, explain the chronic US trade deficit. Explain the sudden capital flight that many countries experienced the last ten years (e.g., Mexico, Thailand, Russia, Argentina, Turkey). Explain the sudden capital flight that many countries experienced the last ten years (e.g., Mexico, Thailand, Russia, Argentina, Turkey).

31 Net Capital Inflows and The Real Interest Rate Net capital inflow KI Domestic real interest rate r 0 Net capital inflows, KI KI > 0 Net capital inflows KI < 0 Net capital outflows

32 An Increase In Risk Reduces Net Capital Inflows Net capital inflow KI Domestic real interest rate r 0 KI KI’ Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets.

33 The Saving-Investment Diagram For An Open Economy Saving and investment Real interest rate (%) I S + KI r* E S I = demand for capital investment funds S + KI = total supply of saving S = domestic supply of saving R* = equilibrium real interest rate