11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 11: Financial Markets and Ch. 11: Financial Markets and International Capital FlowsInternational Capital Flows

22

Savings and InvestmentsSavings and Investments

National savings done by governments, National savings done by governments, households and businesses will not be households and businesses will not be channeled into investments if there is no channeled into investments if there is no intermediary to bring the two sides intermediary to bring the two sides together.together.

Even if there were intermediaries, Even if there were intermediaries, investments may not be productive and investments may not be productive and resources may be wasted, condemning resources may be wasted, condemning the future generations to poverty.the future generations to poverty.

33

SavingsSavings Lack of options for households may force them to Lack of options for households may force them to

keep their wealth in money form.keep their wealth in money form. A relatively high inflation would wipe out most of their A relatively high inflation would wipe out most of their

wealth.wealth.

In many poor countries, households keep their In many poor countries, households keep their wealth in gold.wealth in gold. In 1980-81, gold prices reached $800/oz.. 2/24/2004: In 1980-81, gold prices reached $800/oz.. 2/24/2004:

$403.45/oz. 3/8/2005: $438.88/oz. 2/13/2007: $664.15$403.45/oz. 3/8/2005: $438.88/oz. 2/13/2007: $664.15

A financial system that can provide trust and A financial system that can provide trust and security to small savers can increase the amount security to small savers can increase the amount of savings in a poor country.of savings in a poor country.

44

InvestmentsInvestments Those that need funds to bring new products or Those that need funds to bring new products or

to expand operations (entrepreneurs and to expand operations (entrepreneurs and managers) are taking risks. They do not know managers) are taking risks. They do not know what the future will hold but given their present what the future will hold but given their present day knowledge they are betting on a positive day knowledge they are betting on a positive outcome.outcome.

If all investments are done through a central If all investments are done through a central office, an unfortunate turn of events can render office, an unfortunate turn of events can render the investment worthless and savings wasted.the investment worthless and savings wasted.

Concentration of risk, political decision-making, Concentration of risk, political decision-making, limited knowledge can waste scarce resources limited knowledge can waste scarce resources and render investments unproductive.and render investments unproductive.

55

Financial SystemFinancial System

A well-developed financial system A well-developed financial system provides many alternatives for savers.provides many alternatives for savers.Different risk levels; different size levels; Different risk levels; different size levels;

different maturities; different liquidity levels.different maturities; different liquidity levels.A well-developed financial system A well-developed financial system

provides scarce and costly information for provides scarce and costly information for lenders, thus reducing the overall risk.lenders, thus reducing the overall risk.

A well-developed financial system A well-developed financial system channels savings to most productive use.channels savings to most productive use.

66

Financial InstitutionsFinancial Institutions

What if someone comes and gives a What if someone comes and gives a brilliant talk on how she can make you a brilliant talk on how she can make you a millionaire if you only gave her $100,000?millionaire if you only gave her $100,000?

Can someone with savings of $1000 have Can someone with savings of $1000 have the means to investigate the validity of the means to investigate the validity of high rate of returns promised?high rate of returns promised?

What if special skills and knowledge is What if special skills and knowledge is required to evaluate claims.required to evaluate claims.

77

Financial InstitutionsFinancial Institutions

Asymmetric information creates a need for Asymmetric information creates a need for specialized institutions to evaluate risk.specialized institutions to evaluate risk.

Comparative advantage leads to Comparative advantage leads to specialization.specialization.

Economies of scale allows financial Economies of scale allows financial institutions to collect information and to institutions to collect information and to channel savings into loans at low cost.channel savings into loans at low cost.

88

Banking Crisis and Banking Crisis and Japanese RecessionJapanese Recession

1980s: Japanese banks made loans in the 1980s: Japanese banks made loans in the bullish real estate market and acquired stock bullish real estate market and acquired stock in corporations.in corporations.

1990s1990sReal estate prices plummeted and many borrowers Real estate prices plummeted and many borrowers

defaulted on their loans.defaulted on their loans.Falling stock prices reduced the value of the Falling stock prices reduced the value of the

banks’ shareholdingsbanks’ shareholdings““Credit crunch” occurred and small businesses Credit crunch” occurred and small businesses

could not get loanscould not get loansJapan fell into a severe recessionJapan fell into a severe recession

99

BondsBonds

A bond is an IOU that indicates the principal to A bond is an IOU that indicates the principal to be paid at maturity (face value), the rate of be paid at maturity (face value), the rate of interest to be earned per year on the principal interest to be earned per year on the principal (coupon rate), and the date the bond will mature (coupon rate), and the date the bond will mature (date the principal will be paid).(date the principal will be paid).

Bonds are issued by borrowers and bought by Bonds are issued by borrowers and bought by lenders.lenders.

During the life of the bond, the holders may During the life of the bond, the holders may decide to sell the bond to someone else.decide to sell the bond to someone else.

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BondsBonds

Bonds issued by different entities carry Bonds issued by different entities carry different coupon rates. Credit risk is the different coupon rates. Credit risk is the most important reason that determines the most important reason that determines the variations in coupon rates in same variations in coupon rates in same maturity bonds.maturity bonds.

Municipal bonds usually have lower Municipal bonds usually have lower coupon rates because they are exempt coupon rates because they are exempt from federal taxation.from federal taxation.

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BondsBonds Joe buys a 2-year government bond (Treasury note) Joe buys a 2-year government bond (Treasury note)

issued on Jan. 1, 2007 with a face-value of $1,000 and a issued on Jan. 1, 2007 with a face-value of $1,000 and a coupon rate of 4%.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 On Jan. 1, 2008 and on Jan. 1, 2009 how much will the

government pay to the holder of this bond?government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2008, what price If Joe wants to sell his bond on Jan. 2, 2008, what price

does he expect to get for his bond ifdoes 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%?

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Bond Prices and Interest RatesBond 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 If Lydia expects to see higher interest

rates in the future, should she buy or sell rates in the future, should she buy or sell bonds today? (Hint: think about capital bonds today? (Hint: think about capital gains and losses).gains and losses).

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StocksStocks

Stocks are shares in the ownership of a Stocks are shares in the ownership of a public company.public company.

Stockholders are paid dividends from the Stockholders are paid dividends from the profits of the company.profits of the company.

If future profits are expected to increase, If future profits are expected to increase, dividends are expected to increase, dividends are expected to increase, creating an extra demand for the stock creating an extra demand for the stock and pushing the price of the stock up and pushing the price of the stock up today.today.

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StocksStocks

When a company issues stock it receives the When a company issues stock it receives the funds to use for expansion, investment.funds to use for expansion, investment.

When existing stocks are bought and sold in the When existing stocks are bought and sold in the stock market, the company gets nothing except stock market, the company gets nothing except a signal that if it wants to raise funds would it be a signal that if it wants to raise funds would it be cheaper or more expensive. cheaper or more expensive.

Since stocks and bonds are substitutes, a rise in Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond prices also interest rates that reduces the bond prices also reduces the stock prices.reduces the stock prices.

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Stock PricesStock Prices Suppose you expect the stock price of IBM to be Suppose you expect the stock price of IBM to be

$100 a year from now and also you expect $100 a year from now and also you expect dividends per share to be $5, then.dividends per share to be $5, then.

Assuming that given the riskiness of IBM, you Assuming that given the riskiness of IBM, you desire to have a return of 8% on your savings, desire to have a return of 8% on your savings, what price are you willing to pay for this stock?what price are you willing to pay for this stock?

Hint: If you were to sell the stock a year from Hint: If you were to sell the stock a year from now, how much would you get and what is the now, how much would you get and what is the present value today that will yield 8% to bring present value today that will yield 8% to bring this amount?this amount?

P (1.08) = $105P (1.08) = $105 P = $105/1.08 = $97.22P = $105/1.08 = $97.22

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Stock PricesStock Prices

If in general, interest rates have risen If in general, interest rates have risen because of inflation, so that you expect because of inflation, so that you expect 10% return rather than 8%, how much 10% return rather than 8%, how much would you pay for the same IBM stock?would you pay for the same IBM stock?

P = $105/1.1 = $95.45P = $105/1.1 = $95.45What if you expected IBM price to be What if you expected IBM price to be

$110?$110?What if you expected dividends to be $10?What if you expected dividends to be $10?

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Stock PricesStock Prices

ObservationsObservations An increase in future dividends or future stock prices An increase in future dividends or future stock prices

will raise the price of the stock today.will raise the price of the stock today. An increase in required rate of return will lower An increase in required rate of return will lower

today’s stock price.today’s stock price. The uncertainty of future earnings and dividends The uncertainty of future earnings and dividends

increases the risk of purchasing a stock.increases the risk of purchasing a stock. Stock market investors account for this risk by Stock market investors account for this risk by

requiring a higher rate of return or requiring a higher rate of return or risk premium.risk premium.

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U.S. Stock Market 1990-2003U.S. Stock Market 1990-2003

During the 1990s boom:During the 1990s boom:Economic growth fueled expectations of Economic growth fueled expectations of

higher dividendshigher dividendsDiversification reduced the risk premiumDiversification reduced the risk premium

The millennium declineThe millennium declineTech failures and scandals lowered the Tech failures and scandals lowered the

dividend expectations.dividend expectations.Risk premium rose in response to the Risk premium rose in response to the

recession, terrorist attacks, and corporate recession, terrorist attacks, and corporate scandals.scandals.

1919

Newly Issued Stocks and BondsNewly Issued Stocks and Bonds

In order to raise funds (to borrow) In order to raise funds (to borrow) businesses can go to the banks or issue businesses can go to the banks or issue new stocks or bonds.new stocks or bonds.

If the future of the business is considered If the future of the business is considered risky, the bonds will carry a high interest risky, the bonds will carry a high interest rate and the stocks will sell at a low price.rate and the stocks will sell at a low price.

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Three Classes of AssetsThree Classes of Assets

BondsBondsStocksStocksMoneyMoneyThey all respond to interest rates.They all respond to interest rates.The higher the interest rate, the lower is The higher the interest rate, the lower is

the quantity of bonds and stocks supplied.the quantity of bonds and stocks supplied. The higher the interest rates, the lower is The higher the interest rates, the lower is

the quantity of money demanded.the quantity of money demanded.

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Information and RiskInformation and Risk

Stock and bond markets allocate scarce Stock and bond markets allocate scarce savings to the best (highest return) users savings to the best (highest return) users building on the information available.building on the information available.

Riskiness shies the savers away; Riskiness shies the savers away; diversification reduces riskiness.diversification reduces riskiness.

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International Capital FlowsInternational Capital Flows

Purchases of foreign real or financial Purchases of foreign real or financial assets are capital outflows.assets are capital outflows.

Sales of real or financial assets to Sales of real or financial assets to foreigners are capital inflows.foreigners are capital inflows.

Capital inflows allows the country as a Capital inflows allows the country as a whole to import more than it exports.whole to import more than it exports.

Trade surplus (NX>0) allows the residents Trade surplus (NX>0) allows the residents of surplus country to accumulate assets in of surplus country to accumulate assets in another country.another country.

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International Capital FlowsInternational Capital Flows

Trade surplus: capital outflowTrade surplus: capital outflowTrade deficit: capital inflow.Trade deficit: capital inflow.KI = -NXKI = -NXNX = -KI (capital outflow)NX = -KI (capital outflow)NX + KI = 0NX + KI = 0

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SavingsSavings

Y = C + I + G + NXY = C + Sp + T

Sp + T = I + G + NX

Sp + (T – G) – NX = I

Private sector savings + Government sector savings + Trade deficit = Investments

National savings + Capital inflow = Investments

Sp + (T – G) = S - NX = KI

National savings = Investments + Capital outflow

S = I + NX

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Understanding Understanding NX + KI = NX + KI = 00

U.S. resident buys a $20,000 Japanese carU.S. resident buys a $20,000 Japanese carThe Japanese car manufacturer receives The Japanese car manufacturer receives

$20,000 and has two options$20,000 and has two optionsHe can buy $20,000 of U.S. goodsHe can buy $20,000 of U.S. goods

U.S. exports = imports or U.S. exports = imports or NX = NX = 0 and 0 and KI = KI = 00NX + KI = NX + KI = 00

He can buy U.S. assets (land, bond, etc.)He can buy U.S. assets (land, bond, etc.) NXNX = -$20,000 = -$20,000 Capital inflow = Capital inflow = KI = KI = $20,000$20,000 NX NX (-$20,000) + (-$20,000) + KIKI ($20,000) = 0 ($20,000) = 0

2626

http://research.stlouisfed.org/publications/iet/us/us.pdf

The U.S. Trade BalanceThe U.S. Trade Balance

2727http://www.census.gov/foreign-trade/statistics/historical/gands.pdf

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International Capital FlowsInternational Capital Flows

Trade balanceTrade balanceDifference between the value of goods Difference between the value of goods

and services exported and importedand services exported and importedNet Capital FlowsNet Capital Flows

Difference between purchases of Difference between purchases of domestic assets by foreigners and the domestic assets by foreigners and the purchase of foreign assets by domestic purchase of foreign assets by domestic residentsresidents

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What Determines Capital FlowsWhat Determines Capital Flows

Return (real interest rates in different Return (real interest rates in different countries)countries)

Risk (riskiness of domestic assets Risk (riskiness of domestic assets increases => both locals and foreigners increases => both locals and foreigners shy away from domestic assets)shy away from domestic assets)

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ExplainExplain

Using the definitional equations, explain Using the definitional equations, explain the chronic US trade deficit.the chronic US trade deficit.

Explain the sudden capital flight that many Explain the sudden capital flight that many countries experienced the last ten years countries experienced the last ten years (e.g., Mexico, Thailand, Russia, Argentina, (e.g., Mexico, Thailand, Russia, Argentina, Turkey).Turkey).

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Net Capital Inflows Net Capital Inflows and The Real Interest Rateand The Real Interest Rate

Net capital inflow KI

Do

mes

tic

real

inte

rest

rat

e r

0

Net capital inflows, KI

KI > 0Net capitalinflows

KI < 0Net capitaloutflows

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An Increase In Risk An Increase In Risk Reduces Net Capital InflowsReduces Net Capital Inflows

Net capital inflow KI

Do

mes

tic

real

inte

rest

rat

e r

0

KI

KI’

Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets.

3333

The Saving-Investment The Saving-Investment Diagram For An Open EconomyDiagram For An Open Economy

Saving and investment

Rea

l in

tere

st r

ate

(%)

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