Frank Bernanke 2 nd Ch 11 Financial

Frank & Bernanke 2 nd Ch. 11: Financial Markets and International Capital Flows

Savings and Investments National savings done by governments, households and businesses will not be channeled into investments if there is no intermediary to bring the two sides together. l Even if there were intermediaries, investments may not be productive and resources may be wasted, condemning the future generations to poverty. l

Savings l Lack of options for households may force them to keep their wealth in money form. l l In many poor countries, households keep their wealth in gold. l l A relatively high inflation would wipe out most of their wealth. In 1980 -81, gold prices reached $800/oz. . 2/24/2004: $403. 45/oz. 3/8/2005: $438. 88/oz. A financial system that can provide trust and security to small savers can increase the amount of savings in a poor country.

Investments l l l Those that need funds to bring new products or to expand operations (entrepreneurs and managers) are taking risks. They do not know what the future will hold but given their present day knowledge they are betting on a positive outcome. If all investments are done through a central office, an unfortunate turn of events can render the investment worthless and savings wasted. Concentration of risk, political decision-making, limited knowledge can waste scarce resources and render investments unproductive.

Financial System l A well-developed financial system provides many alternatives for savers. l Different risk levels; different size levels; different maturities; different liquidity levels. A well-developed financial system provides scarce and costly information for lenders, thus reducing the overall risk. l A well-developed financial system channels savings to most productive use. l

Financial Institutions What if someone comes and gives a brilliant talk on how she can make you a millionaire if you only gave her $100, 000? l Can someone with savings of $1000 have the means to investigate the validity of high rate of returns promised? l What if special skills and knowledge is required to evaluate claims. l

Financial Institutions Asymmetric information creates a need for specialized institutions to evaluate risk. l Comparative advantage leads to specialization. l Economies of scale allows financial institutions to collect information and to channel savings into loans at low cost. l

Bonds l l l A bond is an IOU that indicates the principal to be paid at maturity (face value), the rate of interest to be earned per year on the principal (coupon rate), and the date the bond will mature (date the principal will be paid). Bonds are issued by borrowers and bought by lenders. During the life of the bond, the holders may decide to sell the bond to someone else.

Bonds issued by different entities carry different coupon rates. Credit risk is the most important reason that determines the variations in coupon rates in same maturity bonds. l Municipal bonds usually have lower coupon rates because they are exempt from federal taxation. l

Bonds l l Joe buys a 2 -year government bond (Treasury note) issued on Jan. 1, 2002 with a face-value of $1, 000 and a coupon rate of 4%. Who is the lender and who is the borrower? On Jan. 1, 2003 and on Jan. 1, 2004 how much will the government pay to the holder of this bond? If Joe wants to sell his bond on Jan. 2, 2003, what price does he expect to get for his bond if l similar bonds pay an interest rate of 4%? l similar bonds pay an interest rate of 3%? l similar bonds pay an interest rate of 5%?

Bond Prices and Interest Rates When interest rates rise, bond prices fall. l When interest rates fall, bond prices rise. l If Lydia expects to see higher interest rates in the future, should she buy or sell bonds today? (Hint: think about capital gains and losses). l

Stocks are shares in the ownership of a public company. l Stockholders are paid dividends from the profits of the company. l If future profits are expected to increase, dividends are expected to increase, creating an extra demand for the stock and pushing the price of the stock up today. l

Stocks l l l When a company issues stock it receives the funds to use for expansion, investment. When existing stocks are bought and sold in the stock market, the company gets nothing except a signal that if it wants to raise funds would it be cheaper or more expensive. Since stocks and bonds are substitutes, a rise in interest rates that reduces the bond prices also reduces the stock prices.

Stock Prices l l l Suppose you expect the stock price of IBM to be $100 a year from now and also you expect dividends per share to be $5, then. Assuming that given the riskiness of IBM, you desire to have a return of 8% on your savings, what price are you willing to pay for this stock? Hint: If you were to sell the stock a year from now, how much would you get and what is the present value today that will yield 8% to bring this amount? P (1. 08) = $105 P = $105/1. 08 = $97. 22

Stock Prices If in general, interest rates have risen because of inflation, so that you expect 10% return rather than 8%, how much would you pay for the same IBM stock? l P = $105/1. 1 = $95. 45 l What if you expected IBM price to be $110? l What if you expected dividends to be $10? l

Newly Issued Stocks and Bonds In order to raise funds (to borrow) businesses can go to the banks or issue new stocks or bonds. l If the future of the business is considered risky, the bonds will carry a high interest rate and the stocks will sell at a low price. l

Three Classes of Assets Bonds l Stocks l Money l They all respond to interest rates. l The higher the interest rates, the lower is the quantity of money demanded. l The higher the interest rate, the lower is the quantity of bonds and stocks supplied. l

Information and Risk Stock and bond markets allocate scarce savings to the best (highest return) users building on the information available. l Riskiness shies the savers away; diversification reduces riskiness. l

International Capital Flows Purchases of real or financial assets across borders are capital outflows. l Sales of real or financial assets are capital inflows. l Capital inflows allows the country as a whole to import more than it exports. l Trade surplus allows the residents of one country to accumulate assets in another country. l

International Capital Flows Trade surplus: capital outflow l Trade deficit: capital inflow. l NX + KI = 0 l KI = -NX l NX = -KI (capital outflow) l

Savings Y = C + I + G + NX Y = C + Sp + T = I + G + NX Sp + (T – G) – NX = I Private sector savings + Government sector savings + Trade deficit = Investments Sp + (T – G) = S - NX = KI National savings + Capital inflow = Investments National savings = Investments + Capital outflow S = I + NX

Explain Given our theories discussed, explain the chronic US trade deficit. l Explain the sudden capital flight that many countries experienced the last ten years (e. g. , Mexico, Thailand, Russia, Argentina, Turkey). l

What Determines Capital Flows Return (real interest rates in different countries) l Risk (riskiness of domestic assets increases => both locals and foreigners shy away from domestic assets) l

International Capital Flows Real Interest Rate Capital outflows NX > 0; KI < 0 0 KI (Capital inflows) NX < 0; KI > 0

Increased Risk Real Interest Rate Capital outflows NX > 0; KI < 0 0 KI (Capital inflows) NX < 0; KI > 0

Closed vs Open Economy Real Interest Rate S S+KI I S, I