Module 7: Financial Markets and International Capital Flows

How are capital inflows and outflows related to domestic investment in new capital goods?

A capital inflow leads to funds flowing into a country, which in turn can be used for domestic investment in new capital goods. A capital inflow allows a country whose productive investment opportunities are greater than domestic savings to finance those investment opportunities by borrowing from abroad, increasing the total amount of investment in new capital goods. Domestic countries who finance domestic capital formation largely through capital inflows must pay interest and dividends to the foreign lenders in the future, which could impose a future burden on the domestic country. However, the hope is that the investment in new capital goods will increase domestic productivity, allowing the borrowing country to pay back its loans while benefiting from increased output and incomes in the meantime. Capital outflows have the opposite effect on investment in new capital. A capital outflow leaves less domestic savings to finance investment opportunities, leading to less investment in new capital goods.

The sum of national saving and capital inflows from abroad must equal: A domestic investment in new capital goods. B capital outflows. C aggregate demand. D the trade deficit.

A domestic investment in new capital goods.

You own shares in a well-managed and diversified company. If a booming economy decreases investors' concerns about market risk, then the price of your shares will __________, holding other factors constant. A increase B decrease C not change D either increase or decrease

A increase

When Federal Reserve actions cause interest rates on newly issued bonds to decrease from 6% to 5%, the prices of existing bonds: A increase. B decrease. C remain unchanged. D decrease only if the coupon rate is less than 5%.

A increase.

You originally required a risk premium of 6 percent in addition to the rate of return on safe assets before you would purchase shares of Techno Company stock. If you and other investors reduce the risk premium you require to 4 percent, the price of Techno Company stock will: A increase. B decrease. C equal the old risk premium plus the new risk premium. D equal the new risk premium plus the rate of return on safe assets.

A increase.

If the United States has a $300 billion trade deficit, then there must be: A net capital inflows of $300 billion. B net capital inflows of -$300 billion. C no capital inflows or capital outflows. D net capital outflows of $300 billion.

A net capital inflows of $300 billion.

Fred purchases a bond, newly issued by the Big Time Corporation, for $10,000. The bond pays $400 to its holder at the end of the first, second, and third years and pays $10,400 upon its maturity at the end of four years. The principal amount of this bond is __________, the coupon rate is __________, and the term of this bond is __________. A $400; 40 percent; four years B $10,000; 4 percent; four years C $10,000; $400; 4 percent D $10,400; 4 percent; four years

B $10,000; 4 percent; four years

One year before maturity, the price of a bond with a principal amount of $1,000 and a coupon rate of 5 percent paid annually fell to $981. The one-year interest rate must be: A 8.5 percent. B 7 percent. C 5 percent. D 1.9 percent.

B 7 percent.

You own shares in a start-up internet company. If large swings in the stock market increase financial investors' concerns about market risk, then the price of your shares will __________, holding other factors constant. A increase B decrease C not change D either increase or decrease

B decrease

When the interest rate on newly issued bonds increases, the price of existing bonds: A increases. B decreases. C increases only if the coupon rate is below the new rate. D may either increase or decrease.

B decreases.

Two reasons savers keep deposits at banks are to: A secure mortgages and to purchase stocks. B earn a return on their savings and to facilitate making payments. C lower interest rates and to increase the money supply. D equalize loan supply and demand and to earn interest.

B earn a return on their savings and to facilitate making payments.

A trade deficit occurs when: A exports exceed imports. B imports exceed exports. C tariffs exceed quotas. D quotas exceed tariffs.

B imports exceed exports.

In an open economy, a decrease in capital inflows __________ the equilibrium domestic real interest rate and __________ the quantity of domestic investment. A increases; increases B increases; decreases C decreases; decreases D decreases; increases

B increases; decreases

The specialized information-gathering activities that banks use to evaluate borrowers are an example of the: A cost-benefit principle. B principle of comparative advantage. C scarcity principle. D principle of increasing opportunity cost.

B principle of comparative advantage.

If domestic saving is less than domestic investment, then a country will have a __________ and positive net capital __________. A trade deficit; outflows B trade deficit; inflows C trade balance; inflows D trade surplus; outflows

B trade deficit; inflows

Sydney purchases a newly-issued, two-year government bond with a principal amount of $10,000 and a coupon rate of 6% paid annually. One year before the bonds matures (and after receiving the coupon payment for the first year), Sydney sells the bond in the bond market. What price (rounded to the nearest dollar) will Sydney receive for his bond if the prevailing interest rate is 5%? A $9,524 B $10,000 C $10,095 D $10,600

C $10,095

You expect a share of EconNews.Com to sell for $65 a year from now. If you are willing to pay $61.06 for one share of the stock today, you expect a dividend payment of $4, and the rate of return on safe assets is 5 percent, how much is your risk premium? A 1.5 percent B 6.5 percent C 8.0 percent D 13.0 percent

C 8.0 percent

During the 1960s and 1970s, the U.S. trade balance was close to zero, but during the 1980s, the trade deficit ballooned to unprecedented levels due to: A an inability of U.S. companies to compete in the international market. B a decline in private saving that resulted from an upsurge in consumption. C a decline in national saving caused largely by rapidly rising government budget deficits. D a worldwide recession that made it difficult for American companies to sell their products abroad.

C a decline in national saving caused largely by rapidly rising government budget deficits.

Each of the following is an example of a financial intermediary EXCEPT a: A commercial bank. B credit union. C bond market. D savings and loan association.

C bond market.

When the Chinese government buys U.S. government bonds, from the perspective of China, this is a(n): A import. B export. C capital outflow. D capital inflow.

C capital outflow.

Holding constant risk and the real returns available abroad, higher domestic real interest rates __________ capital inflows, __________ capital outflows, and __________ net capital inflows. A increase; increase; increase B increase; increase; decrease C increase; decrease; increase D decrease; decrease; decrease

C increase; decrease; increase

The coupon rate is the: A amount originally lent. B regular payment of interest to a bondholder. C interest rate promised when a bond is issued. D maximum interest rate that can be paid on a bond.

C interest rate promised when a bond is issued.

The current price of a stock increases when: A expected future dividends decrease. B the expected future price of the stock decreases. C interest rates decrease. D the perceived riskiness of the stock increases.

C interest rates decrease.

The financial system consists of financial __________, such as commercial banks, and financial markets, such as the stock market. A corporations B allocations C intermediaries D brokers

C intermediaries

The coupon rate on newly issued bonds is usually higher for bonds with __________ terms and __________ risk that the borrower will go bankrupt. A shorter; greater B shorter; smaller C longer; greater D longer; smaller

C longer; greater

An economy with a trade surplus must also have: A a trade deficit. B a budget surplus. C positive net capital outflows. D positive net capital inflows.

C positive net capital outflows.

The rate of return that financial investors require to hold a risky asset minus the rate of return on a safe asset is called the: A real interest rate. B nominal interest rate. C risk premium. D discount rate.

C risk premium.

You expect a share of EconNews.Com to sell for $65 a year from now. If you are willing to pay $62.73 for one share of the stock today, and you expect a dividend payment of $4, what rate of return do you require? A 3.6 percent B 6.2 percent C 6.4 percent D 10 percent

D 10 percent

In the United States saving is allocated to its most productive use by: A the Federal Reserve. B the Federal, state, and local governments. C regulations and laws designed to improve productivity. D a decentralized, market-oriented financial system.

D a decentralized, market-oriented financial system.

When a U.S. oil company purchases oil from Saudi Arabia and the Saudi Arabian firm uses the proceeds from the sale to buy transportation services from the U.S., U.S. net exports __________ and the capital inflow to the United States __________. A are positive; is negative B are negative; is positive C are negative; is negative D are unchanged; is unchanged

D are unchanged; is unchanged

Financial intermediaries, such as commercial banks, provide benefits to: A savers only. B borrowers only. C the government only. D both savers and borrowers.

D both savers and borrowers.

When a Peruvian buys a U.S. government bond, from the perspective of US, this is a(n): A import. B export. C capital outflow. D capital inflow.

D capital inflow.

In an open economy with a given level of real interest rates and risk, an increase in real interest rates abroad will __________ capital inflows and __________ the equilibrium domestic real interest rate. A increase; increase B increase; decrease C decrease; decrease D decrease; increase

D decrease; increase

In an open economy, a decrease in the government's budget deficit will __________ the domestic real interest rate and __________ the level of capital investment in the country, holding other factors constant. A increase; increase B increase; decrease C decrease; decrease D decrease; increase

D decrease; increase

The benefits of net capital inflows to a country include all of the following except: A a larger pool of total savings. B a higher rate of investment in new capital. C a potentially higher growth rate. D interest and dividend payments owed to foreign investors.

D interest and dividend payments owed to foreign investors.

A financial intermediary that sells shares in itself to the public, and then uses the funds to buy a wide variety of financial assets is called a: A commercial bank. B credit union. C stock exchange. D mutual fund.

D mutual fund.

Decentralized market-based financial systems improve the allocation of saving by: A ensuring capital gains exceed dividend payments. B eliminating the need for commercial banks or other financial intermediaries. C matching net capital inflows to net capital outflows. D providing information and risk-sharing services.

D providing information and risk-sharing services.

International capital flows are: A purchases of foreign goods or services. B sales of domestic goods or services to foreigners. C exports plus imports. D purchases or sales of real and financial assets across international borders.

D purchases or sales of real and financial assets across international borders.

If domestic saving is greater than domestic investment, then a country will have a __________ and positive net capital __________. A trade deficit; outflows B trade deficit; inflows C trade surplus; inflows D trade surplus; outflows

D trade surplus; outflows

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: S = 1,500 + 2,000r I = 2,000 - 4000r KI = - 100 + 6000r Assuming that the market for saving and investment is in equilibrium, find national saving, capital inflows, domestic investment and the real interest rate.

Equilibrium in the market for saving and investment requires S + KI = I (1,500 + 2,000r) + (-100 + 6,000r) = 2,000 - 4,000r 12,000r = 600 r= 0.05 = 5% Given that the real interest rate is 5%, we can find that domestic saving is 1,500 + 2,000(0.05) = 1,600, capital inflows are -100 + 6,000(0.05) = 200, and investment is 2,000 - 4,000(0.05) = 1,800.

Explain with examples why a country's net capital inflow must equal its trade deficit in any given period.

If a country imports a good or service, it must pay for that import somehow. If it pays for the import by selling an export of equal value, then the trade balance is zero and the capital inflow is also zero. If it pays for the import by selling a financial asset or by borrowing from abroad, then the country experiences a capital inflow equal in value to the import. Thus its net capital inflow equals its trade deficit.

Suppose that you are much less concerned about risk than the typical person. Are stocks a good financial investment for you? Why or why not?

Stock values are fairly volatile and so carry a risk premium. In other words, the typical investor will hold stocks only if she expects to earn a higher return on average holding stocks than holding a safer asset, such as government bonds. If the relative riskiness of stocks does not bother you, then stocks are a good financial investment because of the higher return that you can expect to earn (on average, but not for certain) by holding them.

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: S = 1,500 + 2,000r I = 2,000 - 4000r KI = - 100 + 6000r 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?

Suppose now that S = 1,380 + 2,000r. The condition S+ KI = I becomes (1,380 + 2,000r) + (-100 + 6,000r) = 2,000 - 4,000r 12,000r= 720 r = 0.06 = 6% Now domestic saving is 1,380 + 2,000(0.06) = 1,500, capital inflows are -100 + 6,000(0.06) = 260, and investment is 2,000 - 4,000(0.06) = 1,760. The reduced domestic saving has raised the domestic real interest rate, which has attracted additional capital inflows from abroad (KI rises from 200 to 260). The extra capital inflows partially offset the decline in domestic saving.

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: S = 1,500 + 2,000r I = 2,000 - 4000r KI = - 100 + 6000r Concern about the economy's macroeconomic policies cause capital inflows to fall sharply so that now KI = - 700 + 6000r. Repeat part a. What does a reduction in capital inflows do to domestic investment and the real interest rate?

The condition S + KI = I becomes (1,500 + 2,000r) + (-700 + 6,000r) = 2,000 - 4,000r 12,000r = 1200 r = 0.10 = 10% Domestic saving is 1,500 + 2,000(0.10) = 1,700; capital inflows are -700 + 6,000(0.10) = -100 (that is, there is a net capital outflow); and investment is 2,000 - 4,000(0.10) = 1,600. Note that the reduction in capital inflows has raised the real interest rate and reduced domestic investment. This illustrates why "capital flight" (sharp increases in capital outflows) is of particular concern for developing countries.