Frank & Bernanke 2ndFrank & Bernanke 2nd

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

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.

SavingsSavings

Lack of options for households may force them Lack of options for households may force them to keep their wealth in money form.to 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.$403.45/oz. 3/8/2005: $438.88/oz. 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.

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.

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.

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.

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.

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.

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.

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

issued on Jan. 1, 2002 with a face-value of $1,000 and a issued on Jan. 1, 2002 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, 2003 and on Jan. 1, 2004 how much will the On Jan. 1, 2003 and on Jan. 1, 2004 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, 2003, what price If Joe wants to sell his bond on Jan. 2, 2003, 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%?

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).

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.

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.

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

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?

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.

Three Classes of AssetsThree Classes of Assets

BondsBondsStocksStocksMoneyMoneyThey all respond to interest rates.They all respond to interest rates.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.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.

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.

International Capital FlowsInternational Capital Flows

Purchases of real or financial assets Purchases of real or financial assets across borders are capital outflows.across borders are capital outflows.

Sales of real or financial assets are capital Sales of real or financial assets are capital inflows.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 allows the residents of one Trade surplus allows the residents of one country to accumulate assets in another country to accumulate assets in another country.country.

International Capital FlowsInternational Capital Flows

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

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

ExplainExplain

Given our theories discussed, explain the Given our theories discussed, explain the chronic US trade deficit.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).

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)

International Capital FlowsInternational Capital FlowsRealInterestRate

KI (Capital inflows)0Capital outflowsNX > 0; KI < 0 NX < 0; KI > 0

Increased RiskIncreased RiskRealInterestRate

KI (Capital inflows)0Capital outflowsNX > 0; KI < 0 NX < 0; KI > 0

Closed vs Open EconomyClosed vs Open Economy

RealInterest Rate

I

SS+KI

S,I