1. Financial Markets
and International
Capital Flows

2. Chapter 24: 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.
Chapter 24: Financial Markets and International Capital Flows

3. The Financial System and the Allocation of Saving to Productive Uses
Key Components of Economic Growth
High rates of savings
An efficient financial system that distributes national savings to the most productive investments
The U.S. financial system:
Is a decentralized market oriented system.
Includes financial institutions and financial markets.
Chapter 24: Financial Markets and International Capital Flows

4. The Financial System and the Allocation of Savings 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 24: Financial Markets and International Capital Flows

5. The Financial System and the Allocation of Savings to Productive Uses
The Banking System
Banks are a financial intermediary between savers and borrowers.
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 24: Financial Markets and International Capital Flows

6. The Financial System and the Allocation of Savings 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.
Banks develop expertise in making small business and consumer loans.
Banks offer services to savers which attract their deposits.
Chapter 24: Financial Markets and International Capital Flows

7. The Financial System and the Allocation of Savings to Productive Uses
Economic Naturalist
How has the banking crisis in Japan affected the Japanese economy?
1980s
Japanese banks made loans in the bullish real estate market and acquired stock in corporations.
Chapter 24: Financial Markets and International Capital Flows

8. The Financial System and the Allocation of Savings 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
“Credit crunch” occurred and small businesses could not get loans
Japan fell into a severe recession
Chapter 24: Financial Markets and International Capital Flows

9. The Financial System and the Allocation of Savings to Productive Uses
Bond
A legal promise to repay a debt, usually including both the principal amount and regular interest payments
Principal Amount
The amount originally lent
Coupon Rate
The interest rate promised when a bond is issued
Chapter 24: Financial Markets and International Capital Flows

10. The Financial System and the Allocation of Savings to Productive Uses
Coupon Payments
Regular interest payments made to the bondholder
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 24: Financial Markets and International Capital Flows

11. The Financial System and the Allocation of Savings to Productive Uses
Bonds
Corporations and governments sell bonds to raise funds.
The longer the term of the bond the higher the coupon rate.
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 24: Financial Markets and International Capital Flows

12. The Financial System and the Allocation of Savings 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 24: Financial Markets and International Capital Flows

13. The Financial System and the Allocation of Savings 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 24: Financial Markets and International Capital Flows

14. The Financial System and the Allocation of Savings to Productive Uses
Stock (or equity)
A claim to partial ownership of a firm
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 24: Financial Markets and International Capital Flows

15. The Financial System and the Allocation of Savings 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%
Stock price x 1.06 = $81
Stock price = $81/1.06 = $76.42
If dividend = $5, stock price = $85/1.06 = $80.19
Chapter 24: Financial Markets and International Capital Flows

16. The Financial System and the Allocation of Savings 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.
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 24: Financial Markets and International Capital Flows

17. 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?
During the 1990s boom:
Economic growth fueled expectations of higher dividends
Diversification reduced the risk premium
Chapter 24: Financial Markets and International Capital Flows

18. 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.
Chapter 24: Financial Markets and International Capital Flows

19. 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 24: Financial Markets and International Capital Flows

20. 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.
International Capital Flows
Purchases or sales of real and financial assets across international borders
Chapter 24: Financial Markets and International Capital Flows

21. International Capital Flows
Purchases or sales of real and financial assets across international borders
Capital Inflows
Purchases of domestic assets by foreign households and firms
Capital Outflows
Purchases of foreign assets by domestic households and firms
Chapter 24: Financial Markets and International Capital Flows

22. 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 24: Financial Markets and International Capital Flows

23. 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
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 24: Financial Markets and International Capital Flows

24. Chapter 24: Financial Markets and International Capital Flows
The U.S. Trade Balance,
Observations
Trade has become increasingly important
Since the 1970s, the U.S. has run trade deficits
Chapter 24: Financial Markets and International Capital Flows

25. 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 24: Financial Markets and International Capital Flows

26. International Capital Flows
Capital Flows and the Balance of Trade
NX = trade balance (net exports)
KI = net capital inflows
NX + KI = 0
Chapter 24: Financial Markets and International Capital Flows

27. 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 24: Financial Markets and International Capital Flows

28. 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 24: Financial Markets and International Capital Flows

29. 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 24: Financial Markets and International Capital Flows

30. Net Capital Inflows and The Real Interest Rate
Net capital inflows, KI
KI > 0
Net capital
inflows
KI < 0
outflows
Domestic real interest rate r
Net capital inflow KI
Chapter 24: Financial Markets and International Capital Flows

31. 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 24: Financial Markets and International Capital Flows

32. An Increase In Risk Reduces Net Capital Inflows
KI’
Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets. KI
Domestic real interest rate r
Net capital inflow KI
Chapter 24: Financial Markets and International Capital Flows

33. International Capital Flows
Savings, Investments, 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 24: Financial Markets and International Capital Flows

34. International Capital Flows
Observation
The pool of savings available for domestic investment includes national savings and the funds from savers abroad.
Chapter 24: Financial Markets and International Capital Flows

35. The Savings-Investment Diagram For An Open Economy
Savings and investments
Real interest rate (%) I
S + KI r* E S
I = demand for capital investment funds
S + KI = total supply of savings
S = domestic supply of savings
r* = equilibrium real interest rate
Chapter 24: Financial Markets and International Capital Flows

36. The Saving-Investment Diagram For An Open Economy
Savings and investments
Real interest rate (%) I
S + KI r* E S
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 savings is reduced in an open economy
Chapter 24: Financial Markets and International Capital Flows

37. 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.
Chapter 24: Financial Markets and International Capital Flows

38. International Capital Flows
Economic Naturalist
Why did the Argentine economy collapse in ?
The Savings Rate and the Trade Deficit
A low rate of national savings is the primary cause of trade deficits.
Chapter 24: Financial Markets and International Capital Flows

39. International Capital Flows
The Savings 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.
Chapter 24: Financial Markets and International Capital Flows

40. International Capital Flows
The Savings Rate and the Trade Deficit
Low national savings imply high consumer and government spending
High rates of spending will:
Increase imports.
Decrease exports.
Chapter 24: Financial Markets and International Capital Flows

41. International Capital Flows
The Savings 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
Chapter 24: Financial Markets and International Capital Flows

42. Chapter 24: Financial Markets and International Capital Flows
National Savings, Investments, and the Trade Balance in the U.S.,
Why is the U.S. trade deficit so large?
Is the U.S. trade deficit a problem?
Chapter 24: Financial Markets and International Capital Flows

43. FDI Inflow per GDP in Groups, %
Avg 90-94
Avg 95-99
Avg 00-04
Avg 05-09
Avg 10-16
Arab World
0.73
0.20
1.24
4.48
1.90
Central Europe and the Baltics
1.31
5.02
4.80
7.62
2.42
East Asia & Pacific
0.70
1.58
1.75
2.48
3.08
Europe & Central Asia
0.96
4.00
4.12
5.97
3.37
European Union
0.99
4.16
4.32
6.34
3.59
Latin America & Caribbean
1.08
4.57
3.13
3.00
3.50
Middle East & North Africa
0.68
0.71
1.52
4.98
1.89
North America
0.60
3.04
1.85
2.00
South Asia
0.22
0.52
0.81
2.23
1.55
Sub-Saharan Africa
0.75
2.70
2.92
3.10
2.52
Mean
0.80
2.65
4.22
2.58
Variance
0.30
1.80
1.41
1.96
STD
0.55
1.06
1.19
1.40
0.87
Source: WDI 2017
Chapter 24: Financial Markets and International Capital Flows

44. FDI Inflow per GDP in Advanced Countries, %
Avg 90-94
Avg 95-99
Avg 00-04
Avg 05-09
Avg 10-16
Australia
1.72
1.78
3.81
2.61
3.48
Canada
0.96
2.42
3.44
4.27
2.91
Germany
0.14
0.98
4.00
1.79
India
0.64
0.85
2.30
1.71
Japan
0.04
0.09
0.19
0.25
0.22
Korea, Rep.
0.24
0.92
1.39
1.07
0.67
United Kingdom
1.68
3.21
4.81
6.79
3.35
United States
0.57
1.60
1.74
1.77
2.05
Mean
0.69
1.45
2.53
2.02
Variance
1.01
1.69
2.06
1.19
STD
0.83
1.30
1.43
1.09
Source: WDI 2017
Chapter 24: Financial Markets and International Capital Flows

45. FDI Outflow per GDP in Groups, %
Avg 90-94
1999
Avg 00-04
Avg 05-09
Avg 10-16
Arab World
0.10
0.21
0.27
1.68
1.34
Central Europe and the Baltics
0.05
0.13
0.58
3.73
0.75
East Asia & Pacific
0.88
0.95
1.33
1.85
2.19
Europe & Central Asia
1.48
8.04
4.77
7.02
3.58
European Union
1.51
8.41
4.97
7.55
3.63
Latin America & Caribbean
0.19
0.52
0.40
1.06
Middle East & North Africa
0.16
0.26
2.17
1.11
North America
1.04
2.59
2.08
2.27
2.21
South Asia
0.01
0.02
0.17
0.99
0.45
Sub-Saharan Africa
0.51
0.70
-0.02
0.68
Mean
0.59
2.18
2.87
1.70
Variance
3.27
1.88
2.49
1.16
STD
0.77
1.13
1.37
1.58
1.08
Source: WDI 2017
Chapter 24: Financial Markets and International Capital Flows

46. FDI Outflow per GDP in Advanced Countries, %
Avg 90-94
Avg 95-99
Avg 00-04
Avg 05-09
Avg 10-16
Australia
0.48
1.00
2.37
0.89
0.42
Canada
1.16
3.47
4.43
3.82
3.38
Germany
1.05
3.37
2.27
3.53
3.12
India
0.01
0.03
0.21
1.22
0.52
Japan
0.73
0.51
0.82
1.53
2.51
Korea, Rep.
0.45
0.85
0.72
1.61
2.17
United Kingdom
2.71
7.31
7.79
6.83
United States
1.03
1.72
1.91
2.11
2.26
Mean
0.95
2.28
2.57
2.69
1.85
Variance
0.81
2.39
2.49
1.98
STD
0.90
1.55
1.58
1.41
1.10
Source: WDI 2017
Chapter 24: Financial Markets and International Capital Flows