CHAPTER 23
How does the financial system work in a modern economy?©Danil Melekhin/Getty Images
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Describe the role of financial intermediaries, such as commercial banks in the financial system, and differentiate between bonds and stocks.
2. LO2Show how the financial market improves the allocation of saving to productive uses.
3. LO3Analyze the factors that determine international capital flows to understand how domestic saving, the trade balance, and net capital flows are related.
An old television ad for an online trading company aired around the turn of the millennium and showed an office worker, call him Ed, sitting in front of his computer. Instead of working, Ed is checking the prices of stocks he bought online. Suddenly his eyes widen, as on the computer screen a graph shows the price of his stock shooting up like a rocket. With a whoop Ed heads down to his boss’s office, delivers a few well-chosen insults, and quits his job. Unfortunately, when Ed returns to his desk to pack up his belongings, the computer screen shows that the price of his stock has fallen as quickly as it rose. The last we hear of Ed are his futile attempts to convince his boss that he was only kidding.
Ed’s story is not a bad metaphor for the behavior of U.S. financial markets–back then, as well as more recently. The 1990s were a boom period in the United States, with strong economic growth, record low unemployment rates, and almost nonexistent inflation. This prosperity was mirrored in the spectacular performance of the stock market. In 1999, the Dow Jones index, a popular measure of stock prices, broke 10,000 and then 11,000 for the first time—almost triple the value of the index five years earlier. Stock prices of start-up companies, particularly high-technology and Internet companies, rose to stunning levels, making billionaires of some entrepreneurs still in their twenties. And the benefits of rising stock prices were not confined to the very rich or the very nerdy. Stock ownership among the general population—including both direct ownership of stocks and indirect ownership through mutual funds and pension plans—reached record levels. The stock market boom, however, was not sustained. High-tech companies did not produce the profits that their investors had hoped for, and stock prices began to drop. Many start-up companies saw their stock become nearly worthless, and the values of even established companies fell by one-third or more.
The bust of the early 2000s, in turn, did not last forever either. By late 2006, the Dow Jones index recovered all the ground it had lost since 2000 and broke 12,000 for the first time. In 2007, it broke 13,000 and then 14,000—before again collapsing, this time to less than 7,000, losing more than half its value, and returning by 2009 to its level more than a decade earlier. Since then, stocks have experienced a new boom, and in early 2018, the Dow broke 26,000 for the first time.
During boom periods, people often begin to think of the stock market as a place to gamble and, maybe, to strike it rich. Some people do get rich playing the market, and some people, like Ed and many real-life investors in stocks in recent decades, lose everything. But the stock market, as well as other financial markets, plays a crucial role in the economy that is not shared by the gambling establishments in Las Vegas or Atlantic City. That role is to ensure that national saving is devoted to the most productive uses.
In Chapter 21, Saving and Capital Formation, we discussed the importance of national saving. Under most circumstances, a high rate of national saving permits a high rate of capital formation, which both economic logic and experience predict will tend to increase labor productivity and living standards. However, creating new capital does not guarantee a richer and more productive economy. History is full of examples of “white elephants”—capital projects in which millions, and even billions, of dollars were invested with little economic benefit: nuclear power plants that were never opened; massive dams whose main effect was to divert water supplies and disrupt the local agriculture; new technologies that just didn’t work as planned.
A healthy economy not only saves adequately, but also invests those savings in a productive way. In market economies, like that of the United States, channeling society’s savings into the best possible capital investments is the role of the financial system: banks, stock markets, bond markets, and other financial markets and institutions. For this reason, many economists have argued that the development of well-functioning financial markets is a crucial precursor to sustained economic growth. In the first part of this chapter, we discuss some major financial markets and institutions and their role in directing saving to productive uses.
Many of the people who purchase stock in U.S. companies are foreigners, looking to the United States for investment opportunities. More broadly, in the modern world, saving often flows across national boundaries; savers purchase financial assets in countries other than their own and borrowers look abroad for sources of financing. Flows of funds between lenders and borrowers located in different countries are referred to as international capital flows. We discuss the international dimension of saving and capital formation in the second part of the chapter. As we will see, for many countries, including the United States, foreign savings provide an important supplement to domestic savings as a means of financing the formation of new capital.
THE FINANCIAL SYSTEM AND THE ALLOCATION OF SAVING TO PRODUCTIVE USES
In Chapter 21, Saving and Capital Formation, we emphasized the importance of high rates of saving and capital formation for economic growth and increased productivity. High rates of saving and investment by themselves are not sufficient, however. A successful economy not only saves, but also uses its savings wisely by applying these limited funds to the investment projects that seem likely to be the most productive. In a market economy like that of the United States, savings are allocated by means of a decentralized, market-oriented financial system. The U.S. financial system consists of both financial institutions, like banks, and financial markets, such as bond markets and stock markets.
The financial system improves the allocation of savings in at least two distinct ways. First, the financial system provides information to savers about which of the many possible uses of their funds are likely to prove most productive and hence pay the highest return. By evaluating the potential productivity of alternative capital investments, the financial system helps to direct savings to its best uses. Second, financial markets help savers to share the risks of individual investment projects. Sharing of risks protects individual savers from bearing excessive risk, while at the same time making it possible to direct savings to projects, such as the development of new technologies, which are risky but potentially very productive as well.
In this section, we briefly discuss three key components of the U.S. financial system: the banking system, the bond market, and the stock market. In doing so, we elaborate on the role of the financial system as a whole in providing information about investment projects and in helping savers to share the risks of lending. In the next section, we add a global dimension and discuss international flows of financial assets through which savers in one country can invest in another country.
THE BANKING SYSTEM
The banking system consists of commercial banks, of which there are thousands in the United States. Commercial banks, whose role in the creation of money was discussed in Chapter 22, Money, Prices, and the Federal Reserve, are privately owned firms that accept deposits from individuals and businesses and use those deposits to make loans. Banks are the most important example of a class of institutions called financial intermediaries, firms that extend credit to borrowers using funds raised from savers. Other examples of financial intermediaries are savings and loan associations and credit unions.
Why are financial intermediaries such as banks, which “stand between” savers and investors, necessary? Why don’t individual savers just lend directly to borrowers who want to invest in new capital projects? The main reason is that, through specialization, banks and other intermediaries develop a comparative advantage in evaluating the quality of borrowers—the information-gathering function that we referred to a moment ago. Most savers, particularly small savers, do not have the time or the knowledge to determine for themselves which borrowers are likely to use the funds they receive most productively. In contrast, banks and other intermediaries have gained expertise in performing the information-gathering activities necessary for profitable lending, including checking out the borrower’s background, determining whether the borrower’s business plans make sense, and monitoring the borrower’s activities during the life of the loan. Because banks specialize in evaluating potential borrowers, they can perform this function at a much lower cost, and with better results, than individual savers could on their own. Banks also reduce the costs of gathering information about potential borrowers by pooling the savings of many individuals to make large loans. Each large loan needs to be evaluated only once, by the bank, rather than separately by each of the hundreds of individuals whose savings may be pooled to make the loan.
Comparative Advantage
Banks help savers by eliminating their need to gather information about potential borrowers and by directing their savings toward higher-return, more productive investments. Banks help borrowers as well, by providing access to credit that might otherwise not be available. Unlike a Fortune 500 corporation, which typically has many ways to raise funds, a small business that wants to buy equipment or remodel its offices will have few options other than going to a bank. Because the bank’s lending officer has developed expertise in evaluating small-business loans, and may even have an ongoing business relationship with the small-business owner, the bank will be able to gather the information it needs to make the loan at a reasonable cost. Likewise, consumers who want to borrow to finish a basement or add a room to a house will find few good alternatives to a bank. In sum, banks’ expertise at gathering information about alternative lending opportunities allows them to bring together small savers, looking for good uses for their funds, and small borrowers with worthwhile investment projects.
In addition to being able to earn a return on their savings, a second reason that people hold bank deposits is to make it easier to make payments. Most bank deposits allow the holder to write a check against them or draw on them using a debit card or ATM card. For many transactions, paying by check or debit card is more convenient than using cash. For example, it is safer to send a check through the mail than to send cash, and paying by check gives you a record of the transaction, whereas a cash payment does not; and it is faster (and often more convenient) to make an electronic transfer from your bank account to that of someone else. Moreover, for transactions such as online purchases from a laptop or a mobile device, cash is simply not an option.
The Economic Naturalist 23.1
What happens to national economies during banking crises?
The economists Carmen Reinhart and Kenneth Rogoff studied the relation between banking crises and several important economic outcomes, including real GDP growth, government finances, and housing prices.1 They looked at dozens of historical banking crisis episodes, spanning many decades, in both emerging and advanced economies. They found that across countries and across time, bank failures are associated with negative outcomes that include deep and prolonged recessions, dramatic increases in government debt, and drops in real estate values.
As Reinhart and Rogoff note, establishing causality from historical data is difficult. But even though most banking crises are not the sole causes of recessions, they certainly amplify them. When a country’s economic growth slows—for example, due to a productivity slowdown—banks suffer because borrowers are less able to pay back their loans. The value of the banks’ assets then deteriorates, confidence in the banks decreases, withdrawals of money increase, and, sometimes, banking panics and bank failures follow. Bank failures, in turn, make it difficult for households and businesses to borrow, further bringing down economic activity. This leads to further deterioration of banks’ balance sheets, withdrawals, loss of confidence, shrinkage of credit, and so on, in a vicious cycle.
When a bank closes down, the expertise it developed as financial intermediary is lost. As discussed in this chapter, the lost expertise includes, for example, personalized knowledge regarding the bank’s small-business customers—knowledge that the bank acquired during years of doing business together. It is therefore not easy for other banks, even if they are still in healthy financial condition, to step in and provide credit to the previous customers of banks that closed. Fixing a banking system that suffered bank failures can therefore be a slow and costly process. In addition to slower economic growth, during this process, many economies have also suffered asset value declines (due to the shortage of access to credit and financing options) and increased levels of government borrowing.
BONDS AND STOCKS
Large and well- established corporations that wish to obtain funds for investment will sometimes go to banks. Unlike the typical small borrower, however, a larger firm usually has alternative ways of raising funds, notably through the corporate bond market and the stock market. We first discuss some of the mechanics of bonds and stocks, and then return to the role of bond and stock markets in allocating saving.
Bonds
A bond is a legal promise to repay a debt, usually including both the principal amount, which is the amount originally lent, and regular interest payments. The promised interest rate when a bond is issued is called the coupon rate. The regular interest payments made to the bondholder are called coupon payments. The coupon payment of a bond that pays interest annually equals the coupon rate times the principal amount of the bond. For example, if the principal amount of a bond is $1,000,000 and its coupon rate is 5 percent, then the annual coupon payment made to the holder of the bond is (0.05)($1,000,000), or $50,000.
Corporations and governments frequently raise funds by issuing bonds and selling them to savers. The coupon rate that a newly issued bond has to promise in order to be attractive to savers depends on a number of factors, including the bond’s term, its credit risk, and its tax treatment. The term of a bond is the length of time before the debt it represents is fully repaid, a period that can range from 30 days to 30 years or more. Generally, lenders will demand a higher interest rate to lend for a longer term. Credit risk is the risk that the borrower will go bankrupt and thus not repay the loan. A borrower that is viewed as risky will have to pay a higher interest rate to compensate lenders for taking the chance of losing all or part of their financial investment. For example, so-called high-yield bonds, less formally known as “junk bonds,” are bonds issued by firms judged to be risky by credit-rating agencies; these bonds pay higher interest rates than bonds issued by companies thought to be less risky.
Bonds also differ in their tax treatment. For example, interest paid on bonds issued by local governments, called municipal bonds, is exempt from federal taxes, whereas interest on other types of bonds is treated as taxable income. Because of this tax advantage, lenders are willing to accept a lower interest rate on municipal bonds.
Bondholders are not required to hold bonds until maturity, the time at which they are supposed to be repaid by the issuer, but are always free to sell their bonds in the bond market, an organized market run by professional bond traders. The market value of a particular bond at any given point in time is called the price of the bond. As it turns out, there is a close relationship between the price of a bond at a given point of time and the interest rate prevailing in financial markets at that time, illustrated by the following example.
EXAMPLE 23.1Bond Prices and Interest Rates
What is the relationship between bond prices and interest rates?
On January 1, 2018, Tanya purchases a newly issued, two-year government bond with a principal amount of $1,000. The coupon rate on the bond is 5 percent, paid annually. Hence Tanya, or whoever owns the bond at the time, will receive a coupon payment of $50 (5 percent of $1,000) on January 1, 2019, and $1,050 (a $50 coupon payment plus repayment of the original $1,000 lent) on January 1, 2020.
On January 1, 2019, after receiving her first year’s coupon payment, Tanya decides to sell her bond to raise the funds to take a vacation. She offers her bond for sale in the bond market. How much can she expect to get for her “used” bond if the prevailing interest rate in the bond market is 6 percent? If the prevailing interest rate is 4 percent?
As we mentioned, the price of a “used” bond at any point in time depends on the prevailing interest rate. Suppose first that, on January 1, 2019, when Tanya takes her bond to the bond market, the prevailing interest rate on newly issued one-year bonds is 6 percent. Would another saver be willing to pay Tanya the full $1,000 principal amount of her bond? No, because the purchaser of Tanya’s bond will receive $1,050 in one year, when the bond matures; whereas if he uses his $1,000 to buy a new one-year bond paying 6 percent interest, he will receive $1,060 ($1,000 principal repayment plus $60 interest) in one year. So Tanya’s bond is not worth $1,000 to another saver.
How much would another saver be willing to pay for Tanya’s bond? Since newly issued one-year bonds pay a 6 percent return, he will buy Tanya’s bond only at a price that allows him to earn at least that return. As the holder of Tanya’s bond will receive $1,050 ($1,000 principal plus $50 interest) in one year, the price for her bond that allows the purchaser to earn a 6 percent return must satisfy the equation
Bond price × 1.06 = $1,050.
Solving the equation for the bond price, we find that Tanya’s bond will sell for $1,050/1.06, or just under $991. To check this result, note that in one year the purchaser of the bond will receive $1,050, or $59 more than he paid. His rate of return is $59/$991, or 6 percent, as expected.
What if the prevailing interest rate had been 4 percent rather than 6 percent? Then the price of Tanya’s bond would satisfy the relationship bond price × 1.04 = $1,050, implying that the price of her bond would be $1,050/1.04, or almost $1,010.
What happens if the interest rate when Tanya wants to sell is 5 percent, the same as it was when she originally bought the bond? You should show that in this case the bond would sell at its face value of $1,000.
This example illustrates a general principle, that bond prices and interest rates are inversely related. When the interest rate being paid on newly issued bonds rises, the price financial investors are willing to pay for existing bonds falls, and vice versa.
CONCEPT CHECK 23.1
Three-year government bonds are issued at a face value (principal amount) of 100 and a coupon rate of 7 percent, interest payable at the end of each year. One year prior to the maturation of these bonds, a headline reads, “Bad Economic News Causes Prices of Bonds to Plunge,” and the story reveals that these three-year bonds have fallen in price to 96. What has happened to interest rates? What is the one-year interest rate at the time of the story?
Issuing bonds is one means by which a corporation or a government can obtain funds from savers. Another important way of raising funds, but one restricted to corporations, is by issuing stock to the public.
Stocks
A share of stock (or equity) is a claim to partial ownership of a firm. For example, if a corporation has 1 million shares of stock outstanding, ownership of one share is equivalent to ownership of one-millionth of the company. Stockholders receive returns on their financial investment in two forms. First, stockholders receive a regular payment called a dividend for each share of stock they own. Dividends are determined by the firm’s management and usually depend on the firm’s recent profits. Second, stockholders receive returns in the form of capital gains when the price of their stock increases (we discussed capital gains and losses in Chapter 21, Saving and Capital Formation).
Prices of stocks are determined through trading on a stock exchange, such as the New York Stock Exchange. A stock’s price rises and falls as the demand for the stock changes. Demand for stocks in turn depends on factors such as news about the prospects of the company. For example, the stock price of a pharmaceutical company that announces the discovery of an important new drug is likely to rise on the announcement, even if actual production and marketing of the drug is some time away, because financial investors expect the company to become more profitable in the future. Example 23.2 illustrates numerically some key factors that affect stock prices.
EXAMPLE 23.2Buying Shares in a New Company
How much should you pay for a share of FortuneCookie.com?
You have the opportunity to buy shares in a new company called FortuneCookie.com, which plans to sell gourmet fortune cookies over the Internet. Your stockbroker estimates that the company will pay $1.00 per share in dividends a year from now and that in a year, the market price of the company will be $80.00 per share. Assuming that you accept your broker’s estimates as accurate, what is the most that you should be willing to pay today per share of FortuneCookie.com? How does your answer change if you expect a $5.00 dividend? If you expect a $1.00 dividend but an $84.00 stock price in one year?
Based on your broker’s estimates, you conclude that in one year, each share of FortuneCookie.com you own will be worth $81.00 in your pocket—the $1.00 dividend plus the $80.00 you could get by reselling the stock. Thus, finding the maximum price you would pay for the stock today boils down to asking how much would you invest today to have $81.00 a year from today. In turn, answering this question requires one more piece of information, which is the expected rate of return that you require in order to be willing to buy stock in this company.
How would you determine your required rate of return to hold stock in FortuneCookie.com? For the moment, let’s imagine that you are not too worried about the potential riskiness of the stock, either because you think that it is a “sure thing” or because you are a devil-may-care type who is not bothered by risk. In that case, you can apply the Cost-Benefit Principle. Your required rate of return to hold FortuneCookie.com should be about the same as you can get on other financial investments, such as government bonds. The available return on other financial investments gives the opportunity cost of your funds. So, for example, if the interest rate currently being offered by government bonds is 6 percent, you should be willing to accept a 6 percent return to hold FortuneCookie.com as well. In that case, the maximum price you would pay today for a share of FortuneCookie satisfies the equation
Cost-Benefit
Stock price × 1.06 = $81.00.
This equation defines the stock price you should be willing to pay if you are willing to accept a 6 percent return over the next year. Solving this equation yields stock price = $81.00/1.06 = $76.42. If you buy FortuneCookie.com for $76.42, then your return over the year will be ($81.00 − $76.42)/$76.42 = $4.58/$71.42 = 6 percent, which is the rate of return you required to buy the stock.
If, instead, the dividend is expected to be $5.00, then the total benefit of holding the stock in one year, equal to the expected dividend plus the expected price, is $5.00 + $80.00, or $85.00. Assuming again that you are willing to accept a 6 percent return to hold FortuneCookie.com, the price you are willing to pay for the stock today satisfies the relationship Stock price × 1.06 = $85.00. Solving this equation for the stock price yields Stock price = $85.00/1.06 = $80.19. Comparing with the previous case, we see that a higher expected dividend in the future increases the value of the stock today. That’s why good news about the future prospects of a company—such as the announcement by a pharmaceutical company that it has discovered a useful new drug—affects its stock price immediately.
If the expected future price of the stock is $84.00, with the dividend at $1.00, then the value of holding the stock in one year is once again $85.00, and the calculation is the same as the previous one. Again, the price you should be willing to pay for the stock is $80.19.
These examples show that an increase in the future dividend or in the future expected stock price raises the stock price today, whereas an increase in the return a saver requires to hold the stock lowers today’s stock price. Since we expect required returns in the stock market to be closely tied to market interest rates, this last result implies that increases in interest rates tend to depress stock prices as well as bond prices.
Our examples also took the future stock price as given. But what determines the future stock price? Just as today’s stock price depends on the dividend shareholders expect to receive this year and the stock price a year from now, the stock price a year from now depends on the dividend expected for next year and the stock price two years from now, and so on.
Ultimately, then, today’s stock price is affected not only by the dividend expected this year but future dividends as well. A company’s ability to pay dividends depends on its earnings. Thus, as we noted in the example of the pharmaceutical company that announces the discovery of a new drug, news about future earnings—even earnings quite far in the future—is likely to affect a company’s stock price immediately.
CONCEPT CHECK 23.2
As in Example 23.2, you expect a share of FortuneCookie.com to be worth $80.00 per share in one year and also to pay a dividend of $1.00 in one year. What should you be willing to pay for the stock today if the prevailing interest rate, equal to your required rate of return, is 4 percent? What if the interest rate is 8 percent? In general, how would you expect stock prices to react if economic news arrives that implies that interest rates will rise in the very near future?
In the examples we have studied, we assumed that you were willing to accept a return of 6 percent to hold FortuneCookie.com, the same return that you could get on a government bond. However, financial investments in the stock market are quite risky in that returns to holding stocks can be highly variable and unpredictable. For example, although you expect a share of FortuneCookie.com to be worth $80.00 in one year, you also realize that there is a chance it might sell as low as $50.00 or as high as $110.00 per share. Most financial investors dislike risk and unpredictability and thus have a higher required rate of return for holding risky assets like stocks than for holding relatively safe assets like government bonds. The difference between the required rate of return to hold risky assets and the rate of return on safe assets, like government bonds, is called the risk premium. The following example illustrates the effect of financial investors’ dislike of risk on stock prices.
EXAMPLE 23.3Riskiness and Stock Prices
What is the relationship between risk and stock prices?
Continuing Example 23.2, suppose that FortuneCookie.com is expected to pay a $1.00 dividend and have a market price of $80.00 per share in one year. The interest rate on government bonds is 6 percent per year. However, to be willing to hold a risky asset like a share of FortuneCookie.com, you require an expected return four percentage points higher than the rate paid by safe assets like government bonds (a risk premium of 4 percent). Hence you require a 10 percent expected return to hold FortuneCookie.com. What is the most you would be willing to pay for the stock now? What do you conclude about the relationship between perceived riskiness and stock prices?
As a share of FortuneCookie.com is expected to pay $81.00 in one year and the required return is 10 percent, we have Stock price × 1.10 = $81.00. Solving for the stock price, we find the price to be $81.00/1.10 = $73.64, less than the price of $76.42 we found when there was no risk premium and the required rate of return was 6 percent. We conclude that financial investors’ dislike of risk, and the resulting risk premium, lowers the prices of risky assets like stocks.
RECAP
THE FINANCIAL SYSTEM AND THE ALLOCATION OF SAVING
· The role of the financial system is allocating saving to productive uses. Three key components of the financial system are the banking system, the bond market, and the stock market.
· Commercial banks are financial intermediaries: they extend credit to borrowers using funds raised from savers.
· Bonds are legal promises to repay a debt. The prices of existing bonds decline when interest rates rise.
· Stocks (or equity) are claims to partial ownership of a firm. Factors affecting stock prices:
1. An increase in expected future dividends or in the expected future market price of a stock raises the current price of the stock.
2. An increase in interest rates, implying an increase in the required rate of return to hold stocks, lowers the current price of stocks.
3. An increase in perceived riskiness, as reflected in an increase in the risk premium, lowers the current price of stocks.
BOND MARKETS, STOCK MARKETS, AND THE ALLOCATION OF SAVINGS
Like banks, bond markets and stock markets provide a means of channeling funds from savers to borrowers with productive investment opportunities. For example, a corporation that is planning a capital investment but does not want to borrow from a bank has two other options: it can issue new bonds, to be sold to savers in the bond market, or it can issue new shares in itself, which are then sold in the stock market. The proceeds from the sales of new bonds or stocks are then available to the firm to finance its capital investment.
How do stock and bond markets help to ensure that available savings are devoted to the most productive uses? As we mentioned earlier, two important functions served by these markets are gathering information about prospective borrowers and helping savers to share the risks of lending.
THE INFORMATIONAL ROLE OF BOND AND STOCK MARKETS
Savers and their financial advisors know that to get the highest possible returns on their financial investments, they must find the potential borrowers with the most profitable opportunities. This knowledge provides a powerful incentive to scrutinize potential borrowers carefully.
For example, companies considering a new issue of stocks or bonds know that their recent performance and plans for the future will be carefully studied by professional analysts on Wall Street and other financial investors. If the analysts and other potential purchasers have doubts about the future profitability of the firm, they will offer a relatively low price for the newly issued shares, or they will demand a high interest rate on newly issued bonds. Knowing this, a company will be reluctant to go to the bond or stock market for financing unless its management is confident that it can convince financial investors that the firm’s planned use of the funds will be profitable. Thus the ongoing search by savers and their financial advisors for high returns leads the bond and stock markets to direct funds to the uses that appear most likely to be productive.
RISK SHARING AND DIVERSIFICATION
Many highly promising investment projects are also quite risky. For example, the successful development of a new drug to lower cholesterol could create billions of dollars in profits for a drug company, but if the drug turns out to be less effective than some others on the market, none of the development costs will be recouped. An individual who lent his or her life savings to help finance the development of the anti-cholesterol drug might enjoy a handsome return but also takes the chance of losing everything. Savers are generally reluctant to take large risks, so without some means of reducing the risk faced by each saver, it might be very hard for the company to find the funds to develop the new drug.
Bond and stock markets help reduce risk by giving savers a means to diversify their financial investments. Diversification is the practice of spreading one’s wealth over a variety of different financial investments to reduce overall risk. The idea of diversification follows from the adage that “you shouldn’t put all your eggs in one basket.” Rather than putting all of his or her savings in one very risky project, a financial investor will find it much safer to allocate a small amount of savings to each of a large number of stocks and bonds. That way, if some financial assets fall in value, there is a good chance that others will rise in value, with gains offsetting losses. The following example illustrates the benefits of diversification.
EXAMPLE 23.4The Benefits of Diversification
What are the benefits of diversification?
Vikram has $1,000 to invest and is considering two stocks, the Smith Umbrella Company and the Jones Suntan Lotion Company. The price of Smith Umbrella stock will rise by 10 percent if it rains but will remain unchanged if the weather is sunny. The price of Jones Suntan stock is expected to rise by 10 percent if it is sunny but will remain unchanged if there is rain. The chance of rain is 50 percent, and the chance of sunshine is 50 percent. How should Vikram invest his $1,000?
If Vikram were to invest all his $1,000 in Smith Umbrella, he has a 50 percent chance of earning a 10 percent return, in the event that it rains, and a 50 percent chance of earning zero, if the weather is sunny. His average return is 50 percent times 10 percent plus 50 percent times zero, or 5 percent. Similarly, an investment in Jones Suntan yields 10 percent return half the time, when it’s sunny, and 0 percent return the other half the time, when it rains, for an average return of 5 percent.
Although Vikram can earn an average return of 5 percent in either stock, investing in only one stock or the other is quite risky since the actual return he receives varies widely depending on whether there is rain or shine. Can Vikram guarantee himself a 5 percent return, avoiding the uncertainty and risk? Yes, all he has to do is put $500 into each of the two stocks. If it rains, he will earn $50 on his Smith Umbrella stock and nothing on his Jones Suntan. If it’s sunny, he will earn nothing on Smith Umbrella but $50 on Jones Suntan. Rain or shine, he is guaranteed to earn $50—a 5 percent return—without risk.
The existence of bond markets and stock markets makes it easy for savers to diversify by putting a small amount of their savings into each of a wide variety of different financial assets, each of which represents a share of a particular company or investment project. From society’s point of view, diversification makes it possible for risky but worthwhile projects to obtain funding, without individual savers having to bear too much risk.
For the typical person, a particularly convenient way to diversify is to buy bonds and stocks indirectly through mutual funds. A mutual fund is a financial intermediary that sells shares in itself to the public and then uses the funds raised to buy a wide variety of financial assets. Holding shares in a mutual fund thus amounts to owning a little bit of many different financial assets, which helps to achieve diversification. The advantage of mutual funds is that it is usually less costly and time-consuming to buy shares in one or two mutual funds than to buy many different stocks and bonds directly. Over the past few decades mutual funds have become increasingly popular in the United States.
The Economic Naturalist 23.2
Why did the U.S. stock market rise sharply and fall sharply in the 1990s and again in the 2000s?
Stock prices soared during the 1990s in the United States. The Standard & Poor’s (S&P) 500 index, which summarizes the stock price performance of 500 major companies, rose 60 percent between 1990 and 1995 and then more than doubled between 1995 and 2000. However, in the first two years of the new millennium, this index lost nearly half its value. Why did the U.S. stock market boom in the 1990s and then bust?
The prices of stocks depend on their purchasers’ expectations about future dividends and stock prices and on the rate of return required by potential stockholders. The required rate of return in turn equals the interest rate on safe assets plus the risk premium. In principle, a rise in stock prices could be the result of increased optimism about future dividends, a fall in the required return, or some combination.
Probably both factors contributed to the boom in stock prices in the 1990s. Dividends grew rapidly in the 1990s, reflecting the strong overall performance of the U.S. economy. Encouraged by the promise of new technologies, many financial investors expected future dividends to be even higher.
There is also evidence that the risk premium that people required to hold stocks fell during the 1990s, thereby lowering the total required return and raising stock prices. One possible explanation for a decline in the risk premium in the 1990s is increased diversification. During that decade, the number and variety of mutual funds available increased markedly. Millions of Americans invested in these funds, including many who had never owned stock before or had owned stock in only a few companies. This increase in diversification for the typical stock market investor may have lowered the perceived risk of holding stocks, which in turn reduced the risk premium and raised stock prices.
After 2000, both of these favorable factors reversed. The growth in dividends was disappointing to stockholders, in large part because many high-tech firms did not prove as profitable as had been hoped. An additional blow was a series of corporate accounting scandals in 2002, in which it became known that some large firms had taken illegal or unethical actions to make their profits seem larger than in fact they were. A number of factors, including a recession, a major terrorist attack, and the accounting scandals, also increased stockholders’ concerns about the riskiness of stocks, so that the risk premium they required to hold stocks rose from its 1990s lows. The combination of lower expected dividends and a higher premium for risk sent stock prices sharply downward.
As you already know, the stock boom and bust that ended around 2002 was by no means the last dramatic roller coaster in U.S. stock values. During the following five years, the S&P 500 almost doubled again, reaching all-time record levels in 2007 before collapsing again in the next 18 months to levels not seen since the 1990s. That latter collapse, of 2007–2008, arose in the context of a financial crisis and a deep recession, which both lowered expected dividends and increased the perceived riskiness of holding stocks. (The financial crisis and recession will be further discussed in later chapters.) Since 2009, stocks have more than fully recovered, and on September 15, 2017, the S&P 500 pushed past the 2,500 milestone for the first time—around 60 percent above the previous records of 2000 and 2007. This recent rally reflects historically low interest rates on safe assets and considerable changes in recent years to stockholders’ expectations and risk perceptions.
RECAP
BOND MARKETS, STOCK MARKETS, AND THE ALLOCATION OF SAVINGS
Two important functions served by bond and stock markets are gathering information about prospective borrowers and helping savers to share the risks of lending through diversification. A convenient way to diversify is to buy bonds and stocks through mutual funds.
INTERNATIONAL CAPITAL FLOWS
Our discussion thus far has focused on financial markets operating within a given country, such as the United States. However, economic opportunities are not necessarily restricted by national boundaries. The most productive use of a U.S. citizen’s savings might be located far from U.S. soil, such as helping to build a factory in Thailand or starting a small business in Poland. Likewise, the best way for a Brazilian saver to diversify her assets and reduce her risks could be to hold bonds and stocks from a number of different countries. Over time, extensive financial markets have developed to permit cross-border borrowing and lending. Financial markets in which borrowers and lenders are residents of different countries are called international financial markets.
International financial markets differ from domestic financial markets in at least one important respect: Unlike a domestic financial transaction, an international financial transaction is subject to the laws and regulations of at least two countries, the country that is home to the lender and the country that is home to the borrower. Thus the size and vitality of international financial markets depend on the degree of political and economic cooperation among countries. For example, during the relatively peaceful decades of the late nineteenth and early twentieth centuries, international financial markets were remarkably highly developed. Great Britain, at the time the world’s dominant economic power, was a major international lender, dispatching its savings for use around the globe. However, during the turbulent years 1914–1945, two world wars and the Great Depression substantially reduced both international finance and international trade in goods and services. The extent of international finance and trade returned to the levels achieved in the late nineteenth century only in the 1980s.
In thinking about international financial markets, it is useful to understand that lending is economically equivalent to acquiring a real or financial asset, and borrowing is economically equivalent to selling a real or financial asset. For example, savers lend to companies by purchasing stocks or bonds, which are financial assets for the lender and financial liabilities for the borrowing firms. Similarly, lending to a government is accomplished in practice by acquiring a government bond—a financial asset for the lender, and a financial liability for the borrower, in this case the government. Savers can also provide funds by acquiring real assets such as land; if I purchase a parcel of land from you, though I am not making a loan in the usual sense, I am providing you with funds that you can use for consuming or investing. In lieu of interest or dividends from a bond or a stock, I receive the rental value of the land that I purchased.
Purchases or sales of real and financial assets across international borders (which are economically equivalent to lending and borrowing across international borders) are known as international capital flows. From the perspective of a particular country, say the United States, purchases of domestic (U.S.) assets by foreigners are called capital inflows ; purchases of foreign assets by domestic (U.S.) households and firms are called capital outflows. To remember these terms, it may help to keep in mind that capital inflows represent funds “flowing in” to the country (foreign savers buying domestic assets), while capital outflows are funds “flowing out” of the country (domestic savers buying foreign assets). The difference between the two flows is expressed as net capital inflows—capital inflows minus capital outflows—or net capital outflows—capital outflows minus capital inflows. Note that capital inflows and outflows are not counted as exports or imports because they refer to the purchase of existing real and financial assets rather than currently produced goods and services. In the U.S., the Bureau of Economic Analysis (BEA)—which was mentioned earlier in the text as the government agency in charge of measuring exports, imports, and the other components of GDP—is also in charge of measuring capital inflows and outflows. Every quarter, the BEA publishes its most recent estimates of capital flows in the “Financial Account” section of its International Transactions Accounts.
From a macroeconomic perspective, international capital flows play two important roles. First, they allow countries whose productive investment opportunities are greater than domestic savings to fill in the gap by borrowing from abroad. Second, they allow countries to run trade imbalances—situations in which the country’s exports of goods and services do not equal its imports of goods and services. The rest of this chapter discusses these key roles. We begin by analyzing the important link between international capital flows and trade imbalances.
CAPITAL FLOWS AND THE BALANCE OF TRADE
In Chapter 17, Measuring Economic Activity: GDP and Unemployment, we introduced the term net exports (NX), the value of a country’s exports less the value of its imports. An equivalent term for the value of a country’s exports less the value of its imports is the trade balance. Because exports need not equal imports in each quarter or year, the trade balance (or net exports) need not always equal zero. If the trade balance is positive in a particular period so that the value of exports exceeds the value of imports, a country is said to have a trade surplus for that period equal to the value of its exports minus the value of its imports. If the trade balance is negative, with imports greater than exports, the country is said to have a trade deficit equal to the value of its imports minus the value of its exports.
Figure 23.1 shows the components of the U.S. trade balance since 1960 (see Figure 16.5 for data extending back to 1929). The blue line represents U.S. exports as a percentage of GDP; the red line, U.S. imports as a percentage of GDP. When exports exceed imports, the vertical distance between the two lines gives the U.S. trade surplus as a percentage of GDP. When imports exceed exports, the vertical distance between the two lines represents the U.S. trade deficit. Figure 23.1 shows first that international trade has become an increasingly important part of the U.S. economy in the past several decades. In 1960, only 5 percent of U.S. GDP was exported, and the value of imports equaled 4.2 percent of U.S. GDP. In 2016, by comparison, 12 percent of U.S. production was sold abroad, and imports amounted to 14.7 percent of U.S. GDP. Second, the figure shows that since the late 1970s the United States has consistently run trade deficits, frequently equal to 2 percent or more of GDP. For a few years in the mid-2000s, these trade deficits ballooned to more than 5 percent of GDP. Why has the U.S. trade balance been in deficit for so long? We will answer that question later in this section.
FIGURE 23.1 The U.S. Trade Balance, 1960–2016.This figure shows U.S. exports and imports as a percentage of GDP. Since the late 1970s, the United States has run a trade deficit, with imports exceeding exports.Source: Bureau of Economic Analysis, www.bea.gov.
The trade balance represents the difference between the value of goods and services exported by a country and the value of goods and services imported by the country. Net capital inflows represent the difference between purchases of domestic assets by foreigners and purchases of foreign assets by domestic residents. There is a precise and very important link between these two imbalances, which is that in any given period, the trade balance and net capital inflows sum to zero. For future reference, let’s write this relationship as an equation:
NX + KI = 0,(23.1)
where NX is the trade balance (the same as net exports) and we use KI to stand for net capital inflows. The relationship given by Equation 23.1 is an identity, meaning that it is true by definition.2
To see why Equation 23.1 holds, consider what happens when (for example) a U.S. resident purchases an imported good—say, a Japanese automobile priced at $20,000. Suppose the U.S. buyer pays by check so that the Japanese car manufacturer now holds $20,000 in an account in a U.S. bank. What will the Japanese manufacturer do with this $20,000? Basically, there are two possibilities.
First, the Japanese company may use the $20,000 to buy U.S.-produced goods and services, such as U.S.-manufactured car parts or Hawaiian vacations for its executives. In this case, the United States has $20,000 in exports to balance the $20,000 automobile import. Because exports equal imports, the U.S. trade balance is unaffected by these transactions (for these transactions, NX = 0). And because no assets are bought or sold, there are no capital inflows or outflows (KI = 0). So under this scenario, the condition that the trade balance plus net capital inflows equals zero, as stated in Equation 23.1, is satisfied.
Alternatively, the Japanese car producer might use the $20,000 to acquire U.S. assets, such as a U.S. Treasury bond or some land adjacent to its plant in Tennessee. In this case, the United States compiles a trade deficit of $20,000, because the $20,000 car import is not offset by an export (NX = −$20,000). But there is a corresponding capital inflow of $20,000, reflecting the purchase of a U.S. asset by the Japanese (KI = $20,000). So once again the trade balance and net capital inflows sum to zero, and Equation 23.1 is satisfied.3
In fact, there is a third possibility, which is that the Japanese car company might swap its dollars to some other party outside the United States. For example, the company might trade its dollars to another Japanese firm or individual in exchange for Japanese yen. However, the acquirer of the dollars would then have the same two options as the car company—to buy U.S. goods and services or acquire U.S. assets—so that the equality of net capital inflows and the trade deficit would continue to hold.
CONCEPT CHECK 23.3
A U.S. saver purchases a $20,000 Japanese government bond. Explain why Equation 23.1 is satisfied no matter what the Japanese government does with the $20,000 it receives for its bond.
THE DETERMINANTS OF INTERNATIONAL CAPITAL FLOWS
Capital inflows, recall, are purchases of domestic assets by foreigners, while capital outflows are purchases of foreign assets by domestic residents. For example, capital inflows into the United States include foreign purchases of items such as the stocks and bonds of U.S. companies, U.S. government bonds, and real assets such as land or buildings owned by U.S. residents. Why would foreigners want to acquire U.S. assets, and, conversely, why would Americans want to acquire assets abroad?
The basic factors that determine the attractiveness of any asset, either domestic or foreign, are return and risk. Financial investors seek high real returns; thus, with other factors (such as the degree of risk and the returns available abroad) held constant, a higher real interest rate in the home country promotes capital inflows by making domestic assets more attractive to foreigners. By the same token, a higher real interest rate in the home country reduces capital outflows by inducing domestic residents to invest their savings at home. Thus, all else being equal, a higher real interest rate at home leads to net capital inflows. Conversely, a low real interest rate at home tends to create net capital outflows, as financial investors look abroad for better opportunities.
Figure 23.2 shows the relationship between a country’s net capital inflows and the real rate of interest prevailing in that country. When the domestic real interest rate is high, net capital inflows are positive (foreign purchases of domestic assets exceed domestic purchases of foreign assets). But when the real interest rate is low, net capital inflows are negative (that is, the country experiences net capital outflows).
FIGURE 23.2 Net Capital Inflows and the Real Interest Rate.Holding constant the degree of risk and the real returns available abroad, a high real interest rate in the home country will induce foreigners to buy domestic assets, increasing capital inflows. A high real rate in the home country also reduces the incentive for domestic savers to buy foreign assets, reducing capital outflows. Thus, all else being equal, the higher the domestic real interest rate r, the higher will be net capital inflows KI.
The effect of risk on capital flows is the opposite of the effect of the real interest rate. For a given real interest rate, an increase in the riskiness of domestic assets reduces net capital inflows, as foreigners become less willing to buy the home country’s assets, and domestic savers become more inclined to buy foreign assets. For example, political instability, which increases the risk of investing in a country, tends to reduce net capital inflows. Figure 23.3 shows the effect of an increase in risk on capital flows: at each value of the domestic real interest rate, an increase in risk reduces net capital inflows, shifting the capital inflows curve to the left.
FIGURE 23.3 An Increase in Risk Reduces Net Capital Inflows.An increase in the riskiness of domestic assets, arising, for example, from an increase in political instability, reduces the willingness of foreign and domestic savers to hold domestic assets. The supply of capital inflows declines at each value of the domestic real interest rate, shifting the KI curve to the left.
CONCEPT CHECK 23.4
For a given real interest rate and riskiness in the home country, how would you expect net capital inflows to be affected by an increase in real interest rates abroad? Show your answer graphically.
SAVING, INVESTMENT, AND CAPITAL INFLOWS
International capital flows have a close relationship to domestic saving and investment. As we will see next, capital inflows augment the domestic saving pool, increasing the funds available for investment in physical capital, while capital outflows reduce the amount of saving available for investment. Thus capital inflows can help to promote economic growth within a country, and capital outflows to restrain it.
To derive the relationship among capital inflows, saving, and investment, recall that total output or income Y must always equal the sum of the four components of expenditure: consumption (C), investment (I), government purchases (G), and net exports (NX). Writing out this identity, we have
Y = C + I + G + NX.
Next, we subtract C + G + NX from both sides of the identity to obtain
Y − C − G − NX = I.
In Chapter 21, Saving and Capital Formation, we saw that national saving S is equal to Y − C − G. Furthermore, Equation 23.1 states that the trade balance plus capital inflows equals zero, or NX + KI = 0, which implies that KI = −NX. If we substitute S for Y − C − G and KI for −NX in the above equation, we find that
S + KI = I.(23.2)
Equation 23.2, a key result, says that the sum of national saving S and capital inflows from abroad KI must equal domestic investment in new capital goods, I. In other words, in an open economy, the pool of saving available for domestic investment includes not only national saving (the saving of the domestic private and public sectors) but funds from savers abroad as well.
Chapter 21, Saving and Capital Formation, introduced the saving-investment diagram, which shows that in a closed economy, the supply of saving must equal the demand for saving. A similar diagram applies to an open economy, except that the supply of saving in an open economy includes net capital inflows as well as domestic saving. Figure 23.4 shows the open-economy version of the saving-investment diagram. The domestic real interest rate is shown on the vertical axis and saving and investment flows on the horizontal axis. As in a closed economy, the downward-sloping curve I shows the demand for funds by firms that want to make capital investments. The solid upward-sloping curve, marked S + KI, shows the total supply of saving, including both domestic saving S and net capital inflows from abroad KI. Also shown, for comparison, is the supply of domestic saving, marked S. You can see that for higher values of the domestic real interest rate, net capital inflows are positive, so the S + KI curve falls to the right of the curve S showing domestic saving only. But at low enough values of the real interest rate r, the economy sustains net capital outflows, as savers look abroad for higher returns on their financial investments. Thus, at low values of the domestic real interest rate, the net supply of savings is lower than it would be in a closed economy, and the S + KI curve falls to the left of the domestic supply of saving curve S. As Figure 23.4 shows, the equilibrium real interest rate in an open economy, r*, is the level that sets the total amount of saving supplied (including capital inflows from abroad) equal to the amount of saving demanded for purposes of domestic capital investment.
FIGURE 23.4 The Saving-Investment Diagram for an Open Economy.The total supply of savings in an open economy is the sum of national saving S and net capital inflows KI. The supply of domestic saving S is shown for comparison. Because a low real interest rate prompts capital outflows (KI < 0), at low values of the domestic interest rate the total supply of saving S + KI is smaller than national saving S. The domestic demand for saving for purposes of capital investment is shown by the curve labeled I. The equilibrium real interest rate r* sets the total supply of saving, including capital inflows, equal to the domestic demand for saving.
Figure 23.4 also indicates how net capital inflows can benefit an economy. A country that attracts significant amounts of foreign capital flows will have a larger pool of total saving and hence both a lower real interest rate and a higher rate of investment in new capital than it otherwise would. The United States and Canada both benefited from large inflows of capital in the early stages of their economic development, as do many developing countries today. Because capital inflows tend to react very sensitively to risk, an implication is that countries that are politically stable and safeguard the rights of foreign investors will attract more foreign capital and thus grow more quickly than countries without those characteristics.
Although capital inflows are generally beneficial to the countries that receive them, they are not costless. Countries that finance domestic capital formation primarily by capital inflows face the prospect of paying interest and dividends to the foreign financial investors from whom they have borrowed. A number of developing countries have experienced debt crises, arising because the domestic investments they made with foreign funds turned out poorly, leaving them insufficient income to pay what they owed their foreign creditors. An advantage to financing domestic capital formation primarily with domestic saving is that the returns from the country’s capital investments accrue to domestic savers rather than flowing abroad.
THE SAVING RATE AND THE TRADE DEFICIT
We have seen that a country’s exports and imports do not necessarily balance in each period. Indeed, the United States has run a trade deficit, with its imports exceeding exports, for many years. What causes trade deficits? Stories in the media sometimes claim that trade deficits occur because a country produces inferior goods that no one wants to buy or because other countries impose unfair trade restrictions on imports. Despite the popularity of these explanations, however, there is little support for them in either economic theory or evidence. For example, the United States has a large trade deficit with China, but no one would claim U.S. goods are generally inferior to Chinese goods. And many developing countries have significant trade deficits even though they, rather than their trading partners, tend to impose the more stringent restrictions on trade.
Economists argue that, rather than the quality of a country’s exports or the existence of unfair trade restrictions, a low rate of national saving is the primary cause of trade deficits.
To see the link between national saving and the trade deficit, recall the identity Y = C + I + G + NX. Subtracting C + I + G from both sides of this equation and rearranging, we get Y − C − G − I = NX. Finally, recognizing that national saving S equals Y − C − G, we can rewrite the relationship as
S − I = NX.(23.3)
Equation 23.3 can also be derived directly from Equations 23.1 and 23.2. According to Equation 23.3, if we hold domestic investment (I) constant, a high rate of national saving S implies a high level of net exports NX, while a low level of national saving implies a low level of net exports. Furthermore, if a country’s national saving is less than its investment, or S < I, then Equation 23.3 implies that net exports NX will be negative. That is, the country will have a trade deficit. The conclusion from Equation 23.3 is that, holding domestic investment constant, low national saving tends to be associated with a trade deficit (NX < 0), and high national saving is associated with a trade surplus (NX > 0).
Why does a low rate of national saving tend to be associated with a trade deficit? A country with a low national saving rate is one in which households and the government have high spending rates, relative to domestic income and production. Since part of the spending of households and the government is devoted to imported goods, we would expect a low-saving, high-spending economy to have a high volume of imports. Furthermore, a low-saving economy consumes a large proportion of its domestic production, reducing the quantity of goods and services available for export. With high imports and low exports, a low-saving economy will experience a trade deficit.
A country with a trade deficit must also be receiving capital inflows, as we have seen. (Equation 23.1 tells us that if a trade deficit exists so that NX < 0, then it must be true that KI > 0—net capital inflows are positive.) Is a low national saving rate also consistent with the existence of net capital inflows? The answer is yes. A country with a low national saving rate will not have sufficient savings of its own to finance domestic investment. Thus there likely will be many good investment opportunities in the country available to foreign savers, leading to capital inflows. Equivalently, a shortage of domestic saving will tend to drive up the domestic real interest rate, which attracts capital flows from abroad.
We conclude that a low rate of national saving tends to create a trade deficit, as well as to promote the capital inflows that must accompany a trade deficit. The Economic Naturalist 23.3 illustrates this effect for the case of the United States.
The Economic Naturalist 23.3
Why is the U.S. trade deficit so large?
As shown by Figure 23.1, U.S. trade was more or less in balance until the mid-1970s. Since the late 1970s, however, the United States has run large trade deficits, particularly in the mid-1980s and even more so since the latter part of the 1990s. Indeed, from 2004 to 2007, the trade deficit was 5 percent or more of U.S. GDP. Why is the U.S. trade deficit so large?
Figure 23.5 shows national saving, investment, and the trade balance for the United States from 1960 to 2016 (all measured relative to GDP). Note that the trade balance has been negative since the late 1970s, indicating a trade deficit. Note also that trade deficits correspond to periods in which investment exceeds national saving, as required by Equation 23.3.4
FIGURE 23.5 National Saving, Investment, and the Trade Balance in the United States, 1960–2016.Since the 1970s, U.S. national saving has fallen below domestic investment, implying a significant trade deficit.Source: Bureau of Economic Analysis, www.bea.gov.
U.S. national saving and investment were roughly in balance in the 1960s and early 1970s, and hence the U.S. trade balance was close to zero during that period. However, U.S. national saving fell sharply during the late 1970s and 1980s. One factor that contributed to the decline in national saving was the large government deficits of the era. Because investment did not decline as much as saving, the U.S. trade deficit ballooned in the 1980s, coming under control only when investment fell during the recession of 1990–1991. Saving and investment both recovered during the 1990s, but in the latter part of the 1990s, national saving dropped again. This time the federal government was not at fault since its budget showed a healthy surplus. Rather, the fall in national saving reflected a decline in private saving, the result of a powerful upsurge in consumption spending. Much of the increase in consumption spending was for imported goods and services, which pushed the trade deficit to record levels.
Following the 2001 recession, large government deficits returned, and as household saving kept declining, by the mid-2000s the trade deficit broke the record again, reaching levels above 5 percent of GDP. The trade deficit changed course following the 2007–2009 recession, shrinking to about 3 percent of GDP, where it remained as of 2016. While saving declined dramatically during these years as a result of large government deficits, investment declined even faster, and has been recovering more slowly.
Is the U.S. trade deficit a problem? The trade deficit implies that the United States is relying heavily on foreign savings to finance its domestic capital formation (net capital inflows). These foreign loans must ultimately be repaid with interest. If the foreign savings are well invested and the U.S. economy grows, repayment will not pose a problem. However, if economic growth in the United States slackens, repaying the foreign lenders will impose an economic burden in the future.
To this point in the book we have discussed a variety of issues relating to the long-run performance of the economy, including economic growth, the sources of increasing productivity and improved living standards, the determination of real wages, and the determinants of saving and capital formation. Beginning with the next chapter, we will take a more short-run perspective, examining first the causes of recessions and booms in the economy and then turning to policy measures that can be used to affect these fluctuations.
RECAP
INTERNATIONAL CAPITAL FLOWS AND THE BALANCE OF TRADE
· Purchases or sales of assets across borders are called international capital flows. If a person, firm, or government in (say) the United States borrows from abroad, we say that there is a capital inflow into the United States. In this case, foreign savers are acquiring U.S. assets. If a person, firm, or government in the United States lends to someone abroad, thereby acquiring a foreign asset, we say that there has been a capital outflow from the United States to the foreign country. Net capital inflows to a given country equal capital inflows minus outflows.
· If a country imports more goods and services than it exports, it must borrow abroad to cover the difference. Likewise, a country that exports more than it imports will lend the difference to foreigners. Thus, as a matter of accounting, the trade balance NX and net capital inflows KI must sum to zero in every period.
· The funds available for domestic investment in new capital goods equal the sum of domestic saving and net capital inflows from abroad. The higher the return and the lower the risk of investing in the domestic country, the greater will be the capital inflows from abroad. Capital inflows benefit an economy by providing more funds for capital investment, but they can become a burden if the returns from investing in new capital goods are insufficient to pay back the foreign lenders.
· An important cause of a trade deficit is a low national saving rate. A country that saves little and spends a lot will tend to import a greater quantity of goods and services than it is able to export. At the same time, the country’s low saving rate implies a need for more foreign borrowing to finance domestic investment spending.
SUMMARY
· Corporations that do not wish to borrow from banks can obtain finance by issuing bonds or stocks. A bond is a legal promise to repay a debt, including both the principal amount and regular interest payments. The prices of existing bonds decline when interest rates rise. A share of stock is a claim to partial ownership of a firm. The price of a stock depends positively on the dividend the stock is expected to pay and on the expected future price of the stock and negatively on the rate of return required by financial investors to hold the stock. The required rate of return in turn is the sum of the return on safe assets and the additional return required to compensate financial investors for the riskiness of stocks, called the risk premium. (LO1)
· Besides balancing saving and investment in the aggregate, financial markets and institutions play the important role of allocating saving to the most productive investment projects. The financial system improves the allocation of saving in two ways: First, it provides information to savers about which of the many possible uses of their funds are likely to prove must productive, and hence pay the highest return. For example, financial intermediaries such as banks develop expertise in evaluating prospective borrowers, making it unnecessary for small savers to do that on their own. Similarly, stock and bond analysts evaluate the business prospects of a company issuing shares of stock or bonds, which determines the price the stock will sell for or the interest rate the company will have to offer on its bond. Second, financial markets help savers share the risks of lending by permitting them to diversify their financial investments. Individual savers often hold stocks through mutual funds, a type of financial intermediary that reduces risk by holding many different financial assets. By reducing the risk faced by any one saver, financial markets allow risky but potentially very productive projects to be funded. (LO1, LO2)
· The trade balance, or net exports, is the value of a country’s exports less the value of its imports in a particular period. Exports need not equal imports in each period. If exports exceed imports, the difference is called a trade surplus, and if imports exceed exports, the difference is called a trade deficit. Trade takes place in assets as well as goods and services. Purchases of domestic assets (real or financial) by foreigners are called capital inflows, and purchases of foreign assets by domestic savers are called capital outflows. Because imports that are not financed by sales of exports must be financed by sales of assets, the trade balance and net capital inflows sum to zero. (LO3)
· The higher the real interest rate in a country, and the lower the risk of investing there, the higher its capital inflows. The availability of capital inflows expands a country’s pool of saving, allowing for more domestic investment and increased growth. A drawback to using capital inflows to finance domestic capital formation is that the returns to capital (interest and dividends) accrue to foreign financial investors rather than domestic residents. (LO3)
· A low rate of national saving is the primary cause of trade deficits. A low-saving, high-spending country is likely to import more than a high-saving country. It also consumes more of its domestic production, leaving less for export. Finally, a low-saving country is likely to have a high real interest rate, which attracts net capital inflows. Because the sum of the trade balance and capital inflows is zero, a high level of net capital inflows is consistent with a large trade deficit. (LO3)
KEY TERMS
bond
capital inflows
capital outflows
coupon payments
coupon rate
diversification
dividend
financial intermediaries
international capital flows
international financial markets
mutual fund
principal amount
risk premium
stock (or equity)
store of value
trade balance
trade deficit
trade surplus
REVIEW QUESTIONS
1. Arjay plans to sell a bond that matures in one year and has a principal value of $1,000. Can he expect to receive $1,000 in the bond market for the bond? Explain. (LO1)
2. Give two ways that the financial system helps to improve the allocation of savings. Illustrate with examples. (LO2)
3. Suppose you are much less concerned about risk than the typical person. Are stocks a good financial investment for you? Why or why not? (LO1, LO2)
4. How are capital inflows or outflows related to domestic investment in new capital goods? (LO3)
5. Explain with examples why, in any period, a country’s net capital inflows equal its trade deficit. (LO3)
6. How would increased political instability in a country likely affect capital inflows, the domestic real interest rate, and investment in new capital goods? Show graphically. (LO3)
PROBLEMS
1. Simon purchases a bond, newly issued by the Amalgamated Corporation, for $1,000. The bond pays $60 to its holder at the end of the first and second years and pays $1,060 upon its maturity at the end of the third year. (LO1)
a. What are the principal amount, the term, the coupon rate, and the coupon payment for Simon’s bond?
b. After receiving the second coupon payment (at the end of the second year), Simon decides to sell his bond in the bond market. What price can he expect for his bond if the one-year interest rate at that time is 3 percent? 8 percent? 10 percent?
c. Can you think of a reason that the price of Simon’s bond after two years might fall below $1,000, even though the market interest rate equals the coupon rate?
2. Shares in Brothers Grimm Inc., manufacturers of gingerbread houses, are expected to pay a dividend of $5 in one year and to sell for $100 per share at that time. How much should you be willing to pay today per share of Grimm: (LO1)
a. If the safe rate of interest is 5 percent and you believe that investing in Grimm carries no risk?
b. If the safe rate of interest is 10 percent and you believe that investing in Grimm carries no risk?
c. If the safe rate of interest is 5 percent but your risk premium is 3 percent?
d. Repeat parts a–c, assuming that Grimm is not expected to pay a dividend but the expected price is unchanged.
3. Your financial investments consist of U.S. government bonds maturing in 10 years and shares in a start-up company doing research in pharmaceuticals. How would you expect each of the following news items to affect the value of your assets? Explain. (LO1)
a. Interest rates on newly issued government bonds rise?
b. Inflation is forecasted to be much lower than previously expected? (Hint: Recall the Fisher effect from Chapter 18, Measuring the Price Level and Inflation.) Assume for simplicity that this information does not affect your forecast of the dollar value of the pharmaceutical company’s future dividends and stock price.
c. Large swings in the stock market increase financial investors’ concerns about market risk. (Assume that interest rates on newly issued government bonds remain unchanged.)
4. You have $1,000 to invest and are considering buying some combination of the shares of two companies, DonkeyInc and ElephantInc. Shares of DonkeyInc will pay a 10 percent return if the Democrats are elected, an event you believe to have a 40 percent probability; otherwise, the shares pay a zero return. Shares of ElephantInc will pay 8 percent if the Republicans are elected (a 60 percent probability), zero otherwise. Either the Democrats or the Republicans will be elected. (LO1, LO2)
a. If your only concern is maximizing your average expected return, with no regard for risk, how should you invest your $1,000?
b. What is your expected return if you invest $500 in each stock? (Hint: Consider what your return will be if the Democrats win and if the Republicans win; then weight each outcome by the probability that event occurs.)
c. The strategy of investing $500 in each stock does not give the highest possible average expected return. Why might you choose it anyway?
d. Devise an investment strategy that guarantees at least a 4.4 percent return, no matter which party wins.
e. Devise an investment strategy that is riskless—that is, one in which the return on your $1,000 does not depend at all on which party wins.
5. How do each of the following transactions affect (1) the trade surplus or deficit and (2) capital inflows or outflows for the United States? Show that in each case, the identity that the trade balance plus net capital inflows equals zero applies. (LO3)
a. A U.S. exporter sells software to Israel. She uses the Israeli shekels received to buy stock in an Israeli company.
b. A Mexican firm uses proceeds from its sale of oil to the United States to buy U.S. government debt.
c. A Mexican firm uses proceeds from its sale of oil to the United States to buy oil drilling equipment from a U.S. firm.
6. Use a diagram like Figure 23.4 (solid lines only) to show the effects of each of the following on the real interest rate and capital investment of a country that is a net borrower from abroad. (LO3)
a. Investment opportunities in the country improve owing to new technologies.
b. The government budget deficit rises.
c. Domestic citizens decide to save more.
d. Foreign investors believe that the riskiness of lending to the country has increased.
7. A country’s domestic supply of saving, domestic demand for saving for purposes of capital formation, and supply of net capital inflows are given by the following equations: (LO3)
S = 1,500 + 2,000r,
I = 2,000 − 4,000r,
KI = −100 + 6,000r.
a. Assuming that the market for saving and investment is in equilibrium, find national saving, capital inflows, domestic investment, and the real interest rate.
b. Repeat part a, assuming that desired national saving declines by 120 at each value of the real interest rate. What effect does a reduction in domestic saving have on capital inflows?
c. Concern about the economy’s macroeconomic policies causes capital inflows to fall sharply so that now KI = −700 + 6,000r. Repeat part a. What does a reduction in capital inflows do to domestic investment and the real interest rate?
ANSWERS TO CONCEPT CHECKS
23.1Since bond prices fell, interest rates must have risen. To find the interest rate, note that bond investors are willing to pay only 96 today for a bond that will pay back 107 (a coupon payment of 7 plus the principal amount of 100) in one year. To find the one-year return, divide 107 by 96 to get 1.115. Thus, the interest rate must have risen to 11.5 percent. (LO1)
23.2The share of stock will be worth $81.00 in one year—the sum of its expected future price and the expected dividend. At an interest rate of 4 percent, its value today is $81.00/1.04 = $77.88. At an interest rate of 8 percent, the stock’s current value is $81.00/1.08 = $75.00. Recall from Example 23.2 that when the interest rate is 6 percent, the value of a share of FortuneCookie.com is $76.42. Since higher interest rates imply lower stock values, news that interest rates are about to rise should cause the stock market to fall. (LO1)
23.3The purchase of the Japanese bond is a capital outflow for the United States, or KI = −$20,000. The Japanese government now holds $20,000. What will it do with these funds? There are basically three possibilities. First, it might use the funds to purchase U.S. goods and services (military equipment, for example). In that case, the U.S. trade balance equals +$20,000, and the sum of the trade balance and capital inflows is zero. Second, the Japanese government might acquire U.S. assets—for example, deposits in U.S. banks. In that case, a capital inflow to the United States of $20,000 offsets the original capital outflow. Both the trade balance and net capital outflows individually are zero, and so their sum is zero.
Finally, the Japanese government might use the $20,000 to purchase non-U.S. goods, services, or assets—oil from Saudi Arabia, for example. But then the non-U.S. recipient of the $20,000 is holding the funds, and it has the same options that the Japanese government did. Eventually, the funds will be used to purchase U.S. goods, services, or assets, satisfying Equation 23.1. Indeed, even if the recipient holds onto the funds (in cash, or as a U.S. bank deposit), they would still count as a capital inflow to the United States, as U.S. dollars or accounts in a U.S. bank are U.S. assets acquired by foreigners. (LO3)
23.4An increase in the real interest rate abroad increases the relative attractiveness of foreign financial investments to both foreign and domestic savers. Net capital inflows to the home country will fall at each level of the domestic real interest rate. The supply curve of net capital inflows shifts left, as in Figure 23.3. (LO3)
1C. Reinhart and K. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).
2For simplicity, we do not discuss in this book the current account balance (CA), a measure that consists of the trade balance (NX) plus two additional components. The two components are net primary income (consisting mostly of investment income—that is, the net inflow of income on U.S.-owned assets abroad) and net secondary income (unilateral current transfers—that is, nonmarket transfers from foreigners to U.S. residents, such as foreign government grants and personal remittances). Technically, Equation 23.1 is not quite correct, and the precise relationship is CA + KI = 0. However, for the U.S., net primary plus secondary income is a relatively small share of the current account balance. Since it makes the discussion easier, we use net exports, rather than the current account balance, in Equation 23.1.
3If the Japanese company simply left the $20,000 in the U.S. bank, it would still count as a capital inflow, since the deposit would still be a U.S. asset acquired by foreigners.
4If you look at Figure 23.5 very carefully, you may notice that in some years the gap between national saving and investment is slightly different from the trade balance. That difference, referred to as statistical discrepancy, results from imperfections in the measurement of these macroeconomic indicators. While typically much smaller, the statistical discrepancy in some years can reach around 2 percent of GDP.