1. MBMC Financial Markets and International Capital Flows Financial Markets and International Capital Flows

2. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 2 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.

3. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 3 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

4. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 4 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.

5. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 5 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

6. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 6 The Financial System and the Allocation of Saving to Productive Uses The Banking System Banks are a financial intermediary between savers and borrowers.

7. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 7 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.

8. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 8 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.

9. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 9 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.

10. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 10 The Financial System and the Allocation of Saving to Productive Uses Economic Naturalist How has the banking crisis in Japan affected the Japanese economy?

11. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 11 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.

12. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 12 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

13. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 13 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

14. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 14 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

15. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 15 The Financial System and the Allocation of Saving to Productive Uses Principal Amount The amount originally lent Coupon Rate The interest rate promised when a bond is issued

16. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 16 The Financial System and the Allocation of Saving to Productive Uses Coupon Payments Regular interest payments made to the bondholder

17. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 17 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

18. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 18 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.

19. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 19 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.

20. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 20 The Financial System and the Allocation of Saving to Productive Uses Example Bond prices and interest rates  Jan 1, 2003 purchase a 2 year government bond oPrinciple amount = $1,000 oCoupon rate = 0.05 oCoupon payment = $1,000 x 0.05 = $50 (Jan 1, 2004) oAt maturity: $1,000 + $50 = $1,050 (Jan 1, 2005), assuming she already spent the earlier $50 coupon.

21. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 21 The Financial System and the Allocation of Saving to Productive Uses Example Bond prices and interest rates  Want to sell the bond on Jan 1, 2004 (after 1 st coupon payment) 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

22. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 22 The Financial System and the Allocation of Saving to Productive Uses Stock (or equity) A claim to partial ownership of a firm

23. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 23 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

24. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 24 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%

25. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 25 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

26. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 26 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.

27. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 27 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.

28. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 28 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?

29. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 29 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

30. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 30 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.

31. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 31 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.

32. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 32 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.

33. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 33 International Capital Flows Purchases or sales of real and financial assets across international borders

34. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 34 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

35. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 35 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)

36. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 36 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

37. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 37 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

38. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 38 The U.S. Trade Balance, 1960 - 2001 Observations Trade has become increasingly important Since the 1970s, the U.S. has run trade deficits

39. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 39 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

40. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 40 International Capital Flows Capital Flows and the Balance of Trade NX = trade balance (net exports) KI = net capital inflows NX + KI = 0

41. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 41 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 oU.S. exports = imports or NX = 0 and KI = 0 oNX + KI = 0

42. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 42 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.) oNX = -$20,000 oCapital inflow = KI = $20,000 oNX (-$20,000) + KI ($20,000) = 0

43. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 43 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.

44. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 44 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

45. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 45 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

46. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 46 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.

47. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 47 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

48. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 48 International Capital Flows Observation The pool of saving available for domestic investment includes national savings and the funds from savers abroad.

49. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 49 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

50. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 50 The Saving-Investment Diagram For An Open Economy Saving and investment 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 saving is reduced in an open economy

51. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 51 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.

52. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 52 International Capital Flows Economic Naturalist Why did the Argentine economy collapse in 2001 - 2002?

53. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 53 International Capital Flows The Saving Rate and the Trade Deficit A low rate of national saving is the primary cause of trade deficits.

54. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 54 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.

55. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 55 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.

56. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 56 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

57. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 57 International Capital Flows Economic Naturalist Why is the U.S. trade deficit so large?

58. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 58 National Saving, Investment, and the Trade Balance in the U.S., 1960 - 2001

59. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Financial Markets and International Capital Flows Slide 59 International Capital Flows What Do You Think? Is the U.S. trade deficit a problem?

60. MBMC End of Chapter End of Chapter