financial markets and international capital flows financial markets and international capital flows...

Financial Marketsand International

Capital Flows

Financial Marketsand International

Capital Flows

Principles of Macroeconomics

Dr. Gabriel X. Martinez

Ave Maria University

Chapter 24: Financial Markets anChapter 24: Financial Markets and International Capital Flowsd International Capital Flows

55Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

The Dow Jones Industrial Average 1994-2003The Dow Jones Industrial Average 1994-2003



The role of financial markets is to ensure The role of financial markets is to ensure national saving is allocated to the most national saving is allocated to the most productive uses.productive uses.

Key Components of Economic GrowthKey Components of Economic Growth High rates of savingHigh rates of saving An efficient financial system that distributes An efficient financial system that distributes

national savings to the most productive national savings to the most productive investmentsinvestments

The Financial System and theThe Financial System and theAllocation of Saving to Productive UsesAllocation of Saving to Productive Uses



The Financial System and theThe Financial System and theAllocation of Saving to Allocation of Saving to UnproductiveUnproductive Uses Uses



Most rich countries’ financial systems:Most rich countries’ financial systems: Decentralized, market-oriented system.Decentralized, market-oriented system. Include financial institutions and financial Include financial institutions and financial

markets.markets.

Financial systems malfunction in most poor Financial systems malfunction in most poor countries.countries. Government interference or conflicts of interestGovernment interference or conflicts of interest Inefficient institutions and weak marketsInefficient institutions and weak markets


This is an important topic for Economic Development,ECO 320



High rates of saving and capital formation High rates of saving and capital formation are important for economic growth and are important for economic growth and increased productivity…increased productivity…

… … but they are not enough.but they are not enough. ““A successful economy not only saves but A successful economy not only saves but

also uses its savings wisely by applying also uses its savings wisely by applying these limited funds to the investment these limited funds to the investment projects that seem likely to be the most projects that seem likely to be the most productive.”productive.”




The Banking SystemThe Banking System Banks are a Banks are a financial intermediary financial intermediary between between

savers and borrowers.savers and borrowers. Other financial intermediaries are Savings and Other financial intermediaries are Savings and

Loans, Credit Unions, Mutual Funds, etc.Loans, Credit Unions, Mutual Funds, etc.




The Banking SystemThe Banking System Banks specialize in Banks specialize in evaluating the quality of a evaluating the quality of a

borrowerborrower and perform the task at a lower cost. and perform the task at a lower cost. Banks develop expertise in making small business Banks develop expertise in making small business

and consumer loans.and consumer loans.

Banks Banks pool savingspool savings, which increases the , which increases the efficiency of making large loans.efficiency of making large loans. Banks offer services to savers which attract their Banks offer services to savers which attract their

deposits.deposits.




BondBond A legal promise to repay a debt, usually A legal promise to repay a debt, usually

including both the principal amount and regular including both the principal amount and regular interest payments.interest payments.


Source: www.rainfall.com/ posters/WWI/catalog11.htm



BondsBonds Corporations and governments sell bonds to Corporations and governments sell bonds to

raise funds.raise funds. Bonds have to pay higher interest rates if:Bonds have to pay higher interest rates if:

• They repay the principal farther into the future;They repay the principal farther into the future;• They are more difficult to resell to other people;They are more difficult to resell to other people;• They are more likely to not be paid back.They are more likely to not be paid back.


This is an important topic for Banking, Money, and Finance, ECO 342



Stock (or equity)Stock (or equity) A claim to partial ownership of a firmA claim to partial ownership of a firm


A share of stock in the Titanic

Source: www.pomexport.com/ O%20-%20Titanic%20Stock%20C...



Two sources of return to stockholdersTwo sources of return to stockholders DividendDividend

A regular payment received by stockholders for A regular payment received by stockholders for each share that they own.each share that they own.

Capital gainCapital gain The difference between the purchase price and The difference between the purchase price and

selling price, when the selling price is higher.selling price, when the selling price is higher.




The uncertainty of future earnings and The uncertainty of future earnings and dividends increases the risk of dividends increases the risk of purchasing a stock.purchasing a stock. Stock market investors account for this risk Stock market investors account for this risk

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

US stock marketUS stock market


i

Risk

Dividends



From some sections of Chapter 21 (The Labor From some sections of Chapter 21 (The Labor Market) and of Chapter 24 (The Financial Market): Market) and of Chapter 24 (The Financial Market):

Study pp. 535 – 553.Study pp. 535 – 553. Answer Questions 2 and 5; and Problems 2, 3, and 4 Answer Questions 2 and 5; and Problems 2, 3, and 4

(pp. 560-561)(pp. 560-561)

Study pp. 617 – 627.Study pp. 617 – 627. Answer Questions 1, 2, and 3; and Problems 2 and 3 Answer Questions 1, 2, and 3; and Problems 2 and 3

(pp. 638-639).(pp. 638-639).

Turn in your work before Monday, December 12.Turn in your work before Monday, December 12.

Extra CreditExtra Credit

International Capital FlowsInternational Capital Flows




Two Macroeconomic Roles for Two Macroeconomic Roles for International Capital FlowsInternational Capital Flows Suppose a country has great investment Suppose a country has great investment

opportunities, but very low savings.opportunities, but very low savings. The country can fill the “savings gap” by The country can fill the “savings gap” by

borrowing from abroad.borrowing from abroad. ““Borrowing from abroad” is an international capital Borrowing from abroad” is an international capital

flow.flow.




Two Macroeconomic Roles for International Two Macroeconomic Roles for International Capital FlowsCapital Flows International capital flows allow countries to run trade International capital flows allow countries to run trade

imbalances.imbalances. To pay for Imports > Exports.To pay for Imports > Exports.

In September 2005, the US sold goods and services worth In September 2005, the US sold goods and services worth $105 billion to foreign countries.$105 billion to foreign countries.

But it bought goods and services worth $171 billion from But it bought goods and services worth $171 billion from abroad.abroad.

It paid for this imbalance by borrowing from abroad and It paid for this imbalance by borrowing from abroad and selling assets to foreigners..selling assets to foreigners..




International financial markets allocate International financial markets allocate savings to productive capital in different savings to productive capital in different countries.countries.

International financial markets are subject International financial markets are subject to the laws of at least two countries.to the laws of at least two countries.



International Capital FlowsInternational Capital Flows International Capital FlowsInternational Capital Flows

Purchases or sales of real and financial Purchases or sales of real and financial assets across international borders.assets across international borders.



International Capital FlowsInternational Capital Flows International Capital FlowsInternational Capital Flows

If a JapaneseIf a Japanese person buys Ford Co. stock…person buys Ford Co. stock… corporation buys Rockefeller Center …corporation buys Rockefeller Center … corporation builds a plant in Kentucky …corporation builds a plant in Kentucky … insurance company deposits funds ininsurance company deposits funds in

a US bank …a US bank …

… … Then you have a international capital flow.Then you have a international capital flow.

This is the basic subject ofInternational Monetary Economics, ECO 421




International Capital Flows are International Capital Flows are FlowsFlows Not stocks.Not stocks.

We measure capital flows We measure capital flows over a period of over a period of timetime..



International Capital FlowsInternational Capital Flows Capital InflowsCapital Inflows

Purchases of domestic assets by foreign Purchases of domestic assets by foreign households and firms.households and firms.

Capital OutflowsCapital Outflows Purchases of foreign assets by domestic Purchases of foreign assets by domestic

households and firms.households and firms.

Home

Home

Foreign

Foreign



International Capital FlowsInternational Capital Flows Trade Balance (or Net Exports)Trade Balance (or Net Exports)

The value of a country’s exports of goods and The value of a country’s exports of goods and services less the value of its imports of goods services less the value of its imports of goods and services in a particular period (quarter or and services in a particular period (quarter or year).year).

NX = X – IMNX = X – IM

It excludes the payment of interest on debt.It excludes the payment of interest on debt. NX + Interest = Current AccountNX + Interest = Current Account



Observations•Trade has become increasingly important•Since the 1970s, the U.S. has run trade deficits

The U.S. TradeThe U.S. TradeBalance, 1960 - 2001Balance, 1960 - 2001




Trade Surplus, NX > 0Trade Surplus, NX > 0 Exports exceed imports.Exports exceed imports. How do foreigners pay for all the extra imports How do foreigners pay for all the extra imports

they buy?they buy?

Trade Deficit , NX < 0Trade Deficit , NX < 0 Imports exceed exports.Imports exceed exports. If we buy more than we sell, how do we pay If we buy more than we sell, how do we pay

for it?for it?



NX + KI = NX + KI = 00




Net Capital FlowsNet Capital Flows Difference between purchases of domestic Difference between purchases of domestic

assets by foreigners and the purchase of assets by foreigners and the purchase of foreign assets by domestic residents.foreign assets by domestic residents.

Trade balanceTrade balance Difference between the value of goods and Difference between the value of goods and

services exported and imported.services exported and imported.




Capital Flows and the Balance of TradeCapital Flows and the Balance of Trade NXNX = trade balance (net exports) = trade balance (net exports) KI KI = net capital inflows= net capital inflows

NX + KI = NX + KI = 00



International Capital FlowsInternational Capital Flows Understanding Understanding NX + KI = NX + KI = 00

U.S. resident buys a $20,000 Japanese U.S. resident buys a $20,000 Japanese automobileautomobile

The Japanese car manufacturer receives The Japanese car manufacturer receives $20,000 and has three options$20,000 and has three options He can buy $20,000 of U.S. goodsHe can buy $20,000 of U.S. goods He can buy U.S. assets (land, bond, etc.)He can buy U.S. assets (land, bond, etc.) He can put the $20,000 in a bank. The bank will He can put the $20,000 in a bank. The bank will

lend them to someone, and that someone will buy lend them to someone, and that someone will buy either US goods or US assets.either US goods or US assets.




American spends $20,000 on Japanese car.American spends $20,000 on Japanese car. If Japanese people buy $20,000 of U.S. If Japanese people buy $20,000 of U.S.

goodsgoods So U.S. exports = imports So U.S. exports = imports NX = NX = 0. Also, 0. Also, KI = KI = 00 NX + KI = NX + KI = 00

If Japanese people buy U.S. assets (land, If Japanese people buy U.S. assets (land, bond, etc.)bond, etc.) US US NXNX = – $20,000 = – $20,000 US Capital inflow = US Capital inflow = KI = KI = $20,000$20,000 NX NX (-$20,000) + (-$20,000) + KIKI ($20,000) = 0 ($20,000) = 0




American spends $20,000 on Japanese car.American spends $20,000 on Japanese car. If Japanese people put the $20,000 in a US If Japanese people put the $20,000 in a US

bank. bank. US Bank deposits are US assets.US Bank deposits are US assets. US US NXNX = – $20,000 = – $20,000 US Capital inflow = US Capital inflow = KI = KI = $20,000$20,000 NX NX (-$20,000) + (-$20,000) + KIKI ($20,000) = 0 ($20,000) = 0


The Determinants of International The Determinants of International Capital FlowsCapital Flows




The Determinants of International Capital The Determinants of International Capital FlowsFlows Real interest rateReal interest rate

High domestic real interest rates will cause net High domestic real interest rates will cause net capital inflows.capital inflows.

• Why?Why?

Low domestic real interest rates will cause net Low domestic real interest rates will cause net capital outflows.capital outflows.

• Why?Why?




The Determinants of International Capital The Determinants of International Capital FlowsFlows Real interest rateReal interest rate

Suppose that in 2005 Japanese bonds have a 5% Suppose that in 2005 Japanese bonds have a 5% return and US bonds have a 5% return.return and US bonds have a 5% return.

If US interest rates drop in 2006 to 4%, whose If US interest rates drop in 2006 to 4%, whose bonds should you buy?bonds should you buy?

• This a K outflow for the USThis a K outflow for the US If US interest rates rise in 2007 to 7%, whose If US interest rates rise in 2007 to 7%, whose

bonds should you buy?bonds should you buy?• This a K inflow for the USThis a K inflow for the US



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

World interest rate, r*

If r>r*, KI > 0

If r<r*, KI < 0



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


Do

mes

tic

real

inte

rest

rat

e r

0

Net capital inflows, KI

KI > 0Net capitalinflows

KI < 0Net capitaloutflows

World interest rate, r*



International Capital FlowsInternational Capital Flows RiskRisk

For a given real interest rate, an increase in For a given real interest rate, an increase in riskinessriskiness in domestic assets will reduce net in domestic assets will reduce net capital inflows and vice versa.capital inflows and vice versa. Suppose there is a political revolution in the Suppose there is a political revolution in the

country; (K country; (K outout)) Or that the government defaults on its debts; (K Or that the government defaults on its debts; (K

outout)) Or that a new government is closely allied with Or that a new government is closely allied with

international financial organizations; (K international financial organizations; (K inin)) Or that GDP rises for that country. (K Or that GDP rises for that country. (K inin))



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


Do

mes

tic

real

inte

rest

rat

e

r

0

KI

KI’

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


Saving, Investment, and Capital Saving, Investment, and Capital InflowsInflows




Saving, Investment, and Capital InflowsSaving, Investment, and Capital Inflows Y = C + I + G + NXY = C + I + G + NX

Subtract Subtract C + G + NX C + G + NX from both sidesfrom both sides

Y - C - G - NX = IY - C - G - NX = I




Y - C - G - NX = IY - C - G - NX = I

National saving (National saving (SS) = ) = Y - C - GY - C - G - NX- NX= KI= KI Because Because NX + KI = 0NX + KI = 0

S + KI = IS + KI = I

Investment needs can be financed by national Investment needs can be financed by national saving and by capital inflows.saving and by capital inflows.



In equilibriumIn equilibrium

Quantity Saved = Quantity Quantity Saved = Quantity InvestedInvested

S + KI = IS + KI = I



Saving and investment

Rea

l in

tere

st r

ate

(%)

I

r* E

S

If the economy is closed• I = demand for capital

investment funds • S = domestic supply of saving• r* = equilibrium real interest

rate

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




Rea

l in

tere

st r

ate

(%)

I

S + KI

r*E

S

If the economy is open• I = demand for capital

investment funds • S + KI = total supply of saving• S = domestic supply of saving• r* = equilibrium real interest

rate





ObservationsObservations A country that attracts foreign capital will have A country that attracts foreign capital will have

lower real interest and higher investment.lower real interest and higher investment. Countries with a stable political environment Countries with a stable political environment

and well defined property rights will attract and well defined property rights will attract more foreign capital.more foreign capital.




Rea

l in

tere

st r

ate

(%)

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





Rea

l in

tere

st r

ate

(%)

I

S’ + KI

r*’E’

• If the government moves to a surplus, National Saving rises at every level of the interest rate.

• The I curve is downward sloping, so interest rates fall and quantity invested rises.


S + KI

r*E




Rea

l in

tere

st r

ate

(%)

I

S + KI’

r*’E’

• If the country experiences a decrease in the level of risk, capital flows in.

• The I curve is downward sloping, so interest rates fall and quantity invested rises.


S + KI

r*E




The Saving Rate and the Trade DeficitThe Saving Rate and the Trade Deficit Low rates of national saving or very high Low rates of national saving or very high

investment rates are the primary causes of investment rates are the primary causes of trade deficits.trade deficits.




The Saving Rate and the Trade DeficitThe Saving Rate and the Trade Deficit Before, we found thatBefore, we found that

S + KI = IS + KI = I Recall that NX = - KI. Rearrange to showRecall that NX = - KI. Rearrange to show

S - I = NXS - I = NX

Assuming Assuming I I is constant,is constant, If If S S decreases, decreases, NXNX decreases, and vice versa. decreases, and vice versa.



International Capital FlowsInternational Capital Flows The Saving Rate and the Trade DeficitThe Saving Rate and the Trade Deficit

Low national saving are often due to high Low national saving are often due to high consumer and government spendingconsumer and government spending

High rates of spending will:High rates of spending will: Increase imports.Increase imports.

• If people consume more, or firms demand more capital If people consume more, or firms demand more capital goods, they will demand foreign consumption/capital goods, they will demand foreign consumption/capital goods.goods.

Decrease exports.Decrease exports.• If people consume more, or firms demand more capital If people consume more, or firms demand more capital

goods, some consumption/capital goods that goods, some consumption/capital goods that would have would have been exported been exported will be purchased domestically.will be purchased domestically.




The Saving Rate and the Trade DeficitThe Saving Rate and the Trade Deficit Suppose there are abundant investment Suppose there are abundant investment

opportunities (maybe because the country is opportunities (maybe because the country is underdeveloped and most needs are still underdeveloped and most needs are still unmet).unmet). Think of the American West.Think of the American West.

Often, there’s little saving, so a shortage of Often, there’s little saving, so a shortage of domestic saving (S>I) will occur.domestic saving (S>I) will occur.

Real interest rates will rise.Real interest rates will rise. Capital will flow in.Capital will flow in.




Economic NaturalistEconomic Naturalist Why is the U.S. trade deficit so large?Why is the U.S. trade deficit so large?



National Saving, Investment, and the National Saving, Investment, and the Trade Balance in the U.S., 1960 – 2006Trade Balance in the U.S., 1960 – 2006

-10%

-5%

0%

5%

10%

15%

20%

25%

Jan-

59

Jan-

61

Jan-

63

Jan-

65

Jan-

67

Jan-

69

Jan-

71

Jan-

73

Jan-

75

Jan-

77

Jan-

79

Jan-

81

Jan-

83

Jan-

85

Jan-

87

Jan-

89

Jan-

91

Jan-

93

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Gross Saving Gross Private Domestic Investment/GDP Current Account/GDP



What have we learned todayWhat have we learned today

The financial market is complex but The financial market is complex but essential.essential.

It is “the circulatory system” of an economy It is “the circulatory system” of an economy because it puts wealth in the hands of because it puts wealth in the hands of people who can use it productively.people who can use it productively.




International capital flowsInternational capital flows Capital Inflows: Purchases of Capital Inflows: Purchases of domesticdomestic assets assets

by by foreignforeign households and firms. households and firms. Capital Outflows: Purchases of Capital Outflows: Purchases of foreignforeign assets assets

by by domesticdomestic households and firms. households and firms. They help finance investment opportunities They help finance investment opportunities

when savings are low.when savings are low. They help pay for imports when exports are low.They help pay for imports when exports are low.




International capital flows, KIInternational capital flows, KI Trade Balance = NX = X – IMTrade Balance = NX = X – IM NX + KI = 0NX + KI = 0 Determinants of Capital InflowsDeterminants of Capital Inflows

High High domestic real interest rates domestic real interest rates will cause net will cause net capital inflows.capital inflows.

Increases in Increases in the level of riskthe level of risk of the domestic of the domestic economy will reduce KI.economy will reduce KI.

• Increases in Increases in foreign real interest rates foreign real interest rates will cause outflows.will cause outflows.




International capital flows, KIInternational capital flows, KI In equilibrium, Quantity Saved = Quantity In equilibrium, Quantity Saved = Quantity

InvestedInvested S + KI = IS + KI = I


r

I

S + KI

E




International capital flows, KIInternational capital flows, KI Low rates of domestic saving increase interest Low rates of domestic saving increase interest

rates, which attract capital inflows.rates, which attract capital inflows. High rates of investmentHigh rates of investment

raise raise rr and capital inflows. and capital inflows. Increases in country riskIncreases in country risk

reduce KI, forcing reduce KI, forcing rr up upand reducing investment.and reducing investment.


r

I

S + KI

E

financial markets and international capital flows financial markets and international capital flows...

Documents

dow jones industrial

computer hardware chapter

productive investmentschapter

diversified industrials

diversified industrials

pharmaceuticals microsoft

pharmaceuticals procter

line insurance att