Chapter 9 Figures

1
(No Transcript)
2
10
Investment, Saving, and the Real Interest Rate
CHAPTER
EYE ONS
Bond Disposable income Stock Crowding-out-ef
fect Saving Saving supply Investment
demand Wealth Gross investment Bond market Net
investment Financial market Financial capital
Stock market Physical capital
3
DEFINITION

• Physical Capital
• Tools, instruments, machines, buildings, and
  other items produced in the past used to produce
  goods and services.
• Financial Capital
• Funds firms use to buy and operate physical
  capital
• Gross Investment
• Total amount spent on new capital goods
• Net Investment
• Change in quantity of capital
• NI GI - Depreciation

4
DEFINITION
5
DEFINITION

• Wealth
• Value of ALL the things that a person owns..
• Savings
• Amount of income NOT paid in taxes OR spent on
  consumption goods and services
• Stock Market
• Bond Market
• Short-Term Securities Market
• Loan Market

MARKETS for FINANCIAL CAPITAL
6
PHYSICAL and FINANCIAL CAPITAL

• Stock Market
• Stock certificate of ownership and claim to the
  profits that a firm makes.
• Stock market financial market where shares of
  companies stocks are traded.
• Bond Market
• Bond promise to pay specified sums of money on
  specified dates it is a debt for the issuer.
• Bond market financial market where bonds issued
  by firms and governments are traded
• Firms often issue ST bonds as a way to get paid
  for sales before the buyer pays
• Mortgage Backed Securities is a type of bond
• Short-Term Securities Market
• Commercial and Treasury billspromises by large
  firms and government to pay an agreed sum 90 days
  in the future.

7
PHYSICAL and FINANCIAL CAPITAL

• Loan Market
• Banks and other financial institutions lower the
  cost of financing firms capital expenditures by
  accepting short-term deposits and making
  longer-term loans.
• Households Purchase big ticket items
• Businesses Short Term loans to
• 1. Buy inventories,
• 2. Extend credit to customers

FINANCIAL INSTITUTIONS and MARKETS

• Finance Markets
• Financial Institution Firm that operates on
  both sides of the market
• Key Financial Institutions
• Investment Banks
• Commercial Banks
• Government Sponsored mortgage lenders
• Pension funds
• Insurance Companies

8
GLOBAL FINANCIAL MARKET

• Risk
• Loan may not be repaid
• Price of a stock or bond might fall
• Riskier the loan higher is the interest rate.
• Risk vs Rate
• Lenders want to earn the highest possible RIR
• Borrowers want to pay the lowest possible RIR
• Lenders and Borrowers will go anywhere in WORLD ?
  GLOBAL FINANCIAL MARKET
• Aggregate of ALL INDIVIDUAL Financial Markets ?
• Loanable Funds Market

9
INSOLVENCY and ILLIQUIDITY

• Net Worth
• Total Market Value borrowed amount
• Solvent Firm
• Firm with a positive net worth
• Insolvent Firm
• Firm with a negative net worth
• When assets are sold and debts are paid the
  owners (stockholders) pay the price
• Illiquid Firm
• Has made long-term loans with borrowed funds AND
• Is faced with sudden demand to repay amount
  larger than cash on hand
• Normally this firm would borrow from another
  institution but if all cash is drying up they go
  bankrupt.

10
INTEREST RATE and ASSET PRICES

• Financial Assets
• Stocks, bonds, short-term securities, and loans
• Interest Rate
• Percentage of the price of the asset
• Thus, Asset Price h Interest Rate i and vice
  versa

11
LOANABLE FUNDS MARKET

• LF USED FOR (DEMAND)
• Business Investment
• Government Budget Deficit
• International Investment and
• Lending
• Quantity of LF demanded
• Depends on RIR and Expected Profit
• Firms Compare RIR with expected profit on new
  capital? investment decisions
• h RIR i Qty LF demanded
• Changes in DLF (shifts)
• Happens when Expected Profit Changes
• h Exp. Profit h amt. invested h DLF
• Objective Influences
• Business cycle, Technological change, Population
  growth
• Subjective Influences (Keynes) animal spirits
• Contagion Effects (Greenspan) irrational
  exuberance
• Investment decision? Forward looking, based on
  subjective feelings
• Optimism h Investment Pessimism i
  Investment

12
LOANABLE FUNDS MARKET

• LF COME FROM (SUPPLY)
• Private Savings (largest part)
• RIR
• Disposable Income
• Wealth
• Expected Future income
• Government Budget Surplus
• International Borrowing
• Quantity of LF supplied
• Depends on Mostly Savings? depends on RIR,
  Disp.Inc., Wealth, Exp.Fut.Inc.
• Firms Compare RIR with expected profit on new
  capital? investment decisions
• h RIR h Savings h Qty LF supplied
• Changes in SLF (shifts)
• Disposable Income h Disp. Inc. h savings
• Wealth h wealth i savings
• Expected Future Income h Exp.Fut.Inc. i savings
• Default Risk h Default Risk i savings

13
LOANABLE FUNDS MARKET

• SHIFTS

14
LOANABLE FUNDS MARKET

• Surplus, Shortage
• Effects of Shifts

15
GOVERNMENT in the LOANABLE FUNDS MARKET

• GDP ? Y CIGNX (Expenditure) NX is 0
  globally
• GDP ? Y CSNT (Total Income)
• CIGNX CSNT
• IG SNT
• I SNT-G
• Investment is financed by Private Savings and
  Govt. Savings
• Total Savings Private Savings Govt. Savings
• Govt. Surplus ? adds to private savings
• Govt. Deficit ? takes away from private savings
  ? decreases amount available for investment
• SLF PSLF GSLF
• h SLF ? iRIR ? iqty private funds hqty
  investment and qty demand

16
GOVERNMENT in the LOANABLE FUNDS MARKET

• Crowding-out-effect
• Tendency for government budget deficit to raise
  the real interest rate and decrease investment
• SURPLUS DEFICIT

17
GOVERNMENT IN LOANABLE FUNDS MARKET

• The Ricardo-Barro Effect
• The proposition that a government budget deficit
  has no effect on the real interest rate or
  investment.
• The Ricardo-Barro effect operates if private
  saving and the private supply of loanable funds
  increase to offset any government budget deficit
  so that the total supply of loanable funds is
  unchanged when the government has a budget
  deficit.
• Most economists regard this outcome unlikely.

18
FORMULAS
NI GI - Depreciation
Asset Price h Interest Rate i

• DLF
• RIR i Qty LF demandedh
• Exp. Profit h amt. invested h DLF
• Optimism h Investment Pessimism i
  Investment

• SLF
• RIR h Savings h Qty LF supplied
• Disp. Inc. h savings
• wealth i savings
• Exp.Fut.Inc. i savings

SLF PSLF GSLF
DLF PDLF GDLF
19
EYE on FINANCIAL CRISIS
What Created the Global Financial Crisis?
Events in the market for loanable funds, on both
the supply side and demand side, created the
global financial crisis. An increase in default
risk decreased the supply of loanable funds. The
disappearance of some major Wall Street
institutions and lowered profit expectations
decreased the demand for loanable funds. These
institutions include Bear Stearns, Lehman
Brothers, Fannie Mae and Freddie Mac, Merrill
Lynch, and AIG.
20
EYE on FINANCIAL CRISIS
What Created the Global Financial Crisis?
But what caused the increase in default risk and
the failure of so many financial
institutions? Between 2002 and 2005, interest
rates were low. There were plenty of willing
borrowers and plenty of willing lenders. Fuelled
by easy loans, home prices rose rapidly. Lenders
bundled their loans into mortgage-backed
securities and sold them to eager buyers around
the world.
21
EYE on FINANCIAL CRISIS
What Created the Global Financial Crisis?
Then, in 2006, interest rates began to rise and
home prices began to fall. People defaulted on
mortgages and banks took losses. Some banks
became insolvent. A downward spiral of lending
was under way.
22
Did the Rescue Plan Crowd Out Investment?
In mid-2007, on the eve of the onset of the
global financial crisis, U.S. investment
expenditure was 2.2 trillion. The government had
a budget deficit of 0.2 trillion. So the
quantity of loanable funds demanded and supplied
was 2.4 trillion. The real interest rate was 3
percent a year. By mid-2009, U.S. investment
expenditure had fallen to 1.5 trillion. The
real interest rate had risen to 4.5 percent a
year.
23
Did the Rescue Plan Crowd Out Investment?
What caused the collapse of investment and the
rise in the real interest rate? During 2008 and
2009, government rescue-plan outlays boosted the
federal budget deficit by 1 trillion. In 2009,
the budget deficit reached 1.2 trillion. To
finance this deficit, the government issued bonds
and the demand for loanable funds increased by 1
trillion.
24
Did the Rescue Plan Crowd Out Investment?
In 2007, the real interest rate was 3 percent a
year. The government budget deficit was 0.2
trillion. Private investment was 2.2 trillion.
25
Did the Rescue Plan Crowd Out Investment?
The rescue-plan expenditures increased the demand
for loanable funds. The real interest rate rose
to 4.5 percent a year. The higher interest rate
decreased private investment to 1.5
trillion. Without the rescue plan, depressed
profit expectations might have reduced investment
more.
26
Your Participation in the Loanable Funds Market

• Think about the amount of saving that you do.
• How much of your disposable income do you save?
  Is it a positive amount or a negative amount?
• If you save a positive amount, what do you do
  with your savings?
• Do you put them in a bank, in the stock market,
  in bonds, or just keep money at home?
• What is the interest rate you earn on your
  savings?

27
Your Participation in the Loanable Funds Market

• If you save a negative amount, just what does
  that mean?
• It means that you have a deficit (like a
  government deficit). Youre spending more than
  your disposable income.
• In this case, how do you finance your deficit? Do
  you get a student loan? Do you run up an
  outstanding credit card balance?
• How much do you pay to finance your negative
  saving (your dissaving)?
• How do you think your saving will change when you
  graduate and get a better-paying job?

28
Your Participation in the Loanable Funds Market

• Also think about the amount of investment that
  you do.
• You are investing in your human capital by being
  in school. What is this investment costing you?
  How are you financing this investment?
• When you graduate, you will need to decide
  whether to invest in an apartment or a house or
  to rent your home.
• How would you make a decision whether to buy or
  rent a home?
• Would it be smart to borrow 300,000 to finance
  the purchase of a home? How would the interest
  rate influence your decision?

29
Investment and Capital 1976-2006
Part (a) shows gross investment and
depreciation. The gap between gross investment
and depreciation is net investment. Part (b)
shows net investment. Part (c) shows the capital
stock.
30
Investment and Capital 1976-2006
Gross investment increases in most years and
increased rapidly during the booming 1990s, but
it decreases in recession yearssee part (a) of
the figure. Recession years are highlighted in
red.
31
Investment and Capital 1976-2006
Depreciation increases in most years. Like gross
investment, net investment increased rapidly
during the 1990s expansion. Because net
investment is always positive, the quantity of
capital increases each year despite huge swings
in net investment because the quantity of capital
is large in comparison to net investment.
32
Interest Rate Puzzle
The real interest rate paid by big corporations
fell from 5.5 percent a year in 2001 to 2.5
percent a year in 2005. Alan Greenspan said he
was puzzled that the real interest rate was
falling when the U.S. government budget deficit
was growing. Why did the real interest rate
fall? The answer lies in the global loanable
funds market.
33
Interest Rate Puzzle
Global saving increased and the supply of
loanable funds increased from SLF01 in 2001 to
SLF05 in 2005. U.S. saving decreased and U.S.
borrowing from the rest of the world increased
strongly during these years. The Chinese,
Japanese, and Germans all have much higher saving
rates than do Americans.