Financial markets: where households invest their current and accumulated past savings (wealth) by purchasing financial/physical assets
Financial asset: a paper claim (currency, stocks, bonds, loans, etc) entitling a buyer to future income from the seller
Loans are financial assets owned by a lender (typically a bank)
Physical asset: claim on tangible object that gives own the right to rent or sell the object as desired
Financial intermediary: an institution extending credit to borrowers using funds raised from saves e.g. banks, savings and loan associations, credit unions, mutual funds, pension funds, etc
Specialize in evaluation of borrower quality
Principle of comparative advantage advantage
Types of Financial Assets
Loans: lending agreement between a lender and a borrower, harder to resell, not as standardized as bonds
Loan-backed securities: assets created by pooling individual loads and selling shares in that pool, called securitization of those assets
This is essentially a way for owners of these assets (which can’t normally be sold themselves) to generate more cash on the assets and make them marketable
Can be preferred because they are more diverse and very liquid
However can be difficult to assess risk and true quality of the asset since so many loans are packed together, one of the reasons for 2008 crisis
Mortgage-backed securities: subset of loan backed, mortgages are pooled and sold as shares to investors
Bond: legal IOU issues by borrower. Bond seller pays fixed sum of interest (coupon rate) each year to repay principle amount (face value). Bonds are highly tradeable, unlike loans e.g. they can be sold before maturity
Stocks: share in the ownership of a company; stockholders receive capital gains when price of stock increases
Why don’t owners just sell bonds for investment needs, and keep 100% of the company themselves? Risk aversion and they raise capital through ownership; once those people own that part of the company, the company doesn’t owe them anything, that individual has accepted the risk of owning the company. Contrast with the company having to pay interest on loans to a bank
Diversification
Makes risky but potentially valuable projects possible; no individual bears the whole risk
Mutual fund is financial intermediary that sells shares in itself to the public, then uses funds to buy variety of financial assets
Diversified asset for saver
Less costly than buying many stocks/bonds directly
Rise and Fall of Stock Market
Increase in stock prices could be result of increased optimism about future gains, or a fall in required rate of return
In 1990s optimism was high with strong dividends and new technology promised, resulting in lower risk premium (premium required for holding the risk of the asset)
Trend reversed after 2000: tech firms less profitable than expected, corporate accounting scandals of 2002, recession
International Capital Flows
Financial markets with borrowers and lenders from different countries and international financial markets
Size of international markets depends on economic and political cooperation between those countries
Lending is the same as buying
Savers lend to firms by purchasing stocks and bonds, lending here is the same as acquiring a real or financial asset
Savers can also lend by buying as real asset like land from a borrower; don’t get interest or dividends, but get to actually own the land and can rent it
Borrowing is the same as selling
Firms borrow from citizens by selling stocks and bonds
Capital Flows
Under the domestic economy of the US
Capital inflow: funds flowing into US, when foreign saves by domestic (US) assets
Capital outflow: funds flowing out of US, when US savers purchase foreign assets
Net capital outflow: capital inflow - capital outflow
Net capital outflow: capital outflow - capital inflow
Capital inflows and outflows not counted as exports and imports because they refer to purchase of existing assets rather than currently produced goods and services
Two roles:
Allow countries whose productive investment opportunities are greater than their domestic savings to fill in the gap by borrowing abroad (i.e. need to tap into foreign savings when domestic is not enough to capitalize on profitable investments)
Allow countries to run trade imbalances because every trade surplus implies net capital outflow while every trade deficit implies net capital inflow.
If exports > imports, have a trade surplus
If imports > exports, have a trade deficit
Higher domestic real interest rate attracts capital inflows from abroad, implying high capital inflow. Also deters domestic funds from leaving country, so low capital outflow
Overall, higher domestic real interest rates imply high net capital inflows. Foreigners want their funds to appreciate at faster rate inside US
The Financial Account
Records investment flows between US and other countries. Possible outflows include:
US deposits in foreign banks
Loans to foreign people
Purchases of foreign stocks
Funding of foreign affiliates of US multinationals
Trade Balance and Net Flows
Trade balance = NX = X - M
Net capital inflow = KI = capital inflow - capital outflow = purchase of US assets by foreigners - foreign purchase by US residents
NX + KI = 0
Recall Y=C+I+G+NX
Domestic savings are S=Y−C−G, and thus S=I+NX, which implies S+KI=I
So domestic savings (S) plus foreign saving (KI) equals domestic investment (I)
Risk and Capital Inflows
Domestic real interest rate (r) and net capital inflows (KI) chart shows as (r) increases, (KI) increases (roughly) logarithmically
For a given real interest rate, an increase in riskiness of domestic assets decreases capital inflows, shifting this curve to the left
This is trivial; foreigners less willing to buy domestic assets due to increased risk
A decrease in risk shifts the curve the other way
At low interest rates we have KI<0, thus S+KI<S or total savings is less than domestic savings
At high interest rates we have KI>0, thus S+KI>S or total savings is more than domestic savings
Can plot the S and I curves, and we will see an equilibrium interest rate r∗ where S+KI curve equals the I curve
Saving Rate and Trade Deficit
Low rate of national saving is primary reason for trade deficits
With S−I=NX, with low level of domestic savings (S) we have low level of net exports (NX). Since we have trade deficit when imports exceed exports, this low domestic savings implies a trade deficit (or at least when S is low enough such that S<I)
This is fairly intuitive: with low domestic savings i.e. greater overall spending by the population
Some of that spending will be done on imports, implying high imports
Some (or most) of that spending will be on domestically produced goods, leaving less to be exported
Hence, high imports and low exports results in a trade deficit as a result of low domestic spending (as is seen in the US)
Low Saving and High Net Capital Inflows
Country with low saving rate will not have enough funds to finance domestic investment expenditures
This leaves good opportunities for foreigners, resulting in net capital inflows
Low domestic savings will raise real interest rates and attract capital inflows that way as well
Thus, low saving economy will see both a trade deficit and high rates of net capital inflows
But is this a problem?
Trade deficit and high net capital inflows means US relies heavily on foreign savings to finance domestic capital formation
These foreign loans have to be repaid with interest, and can be a problem is US economy does not grow at a healthy rate to keep up
Another drawback is that higher levels of foreign inflow (KI) to finance capital formation means that returns to capital go to foreign investors rather than domestic residents