Investment, Saving, and the Real Interest Rate

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Investment, Saving, and the Real Interest Rate CHAPTER10

EYE ONS

Bond Disposable incomeStock Crowding-out-effectSaving Saving supplyInvestment demand WealthGross investment Bond marketNet investment Financial marketFinancial capital Stock marketPhysical capital

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

DEFINITION

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 MarketBond MarketShort-Term Securities MarketLoan Market

MARKETS for FINANCIAL CAPITAL

PHYSICAL and FINANCIAL CAPITAL

Stock MarketStock certificate of ownership and claim to the profits that a firm makes.Stock market financial market where shares of companies’ stocks are traded.

Bond MarketBond 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 MarketCommercial and Treasury bills—promises by large firms and government to pay an agreed sum 90 days in the future.

PHYSICAL and FINANCIAL CAPITALLoan MarketBanks 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 itemsBusinesses – Short Term loans to 1. Buy inventories, 2. Extend credit to customers

FINANCIAL INSTITUTIONS and MARKETS

Finance MarketsFinancial 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

GLOBAL FINANCIAL MARKET

RiskLoan may not be repaidPrice of a stock or bond might fallRiskier the loan = higher is the interest rate.

Risk vs RateLenders 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

INSOLVENCY and ILLIQUIDITY

Net Worth =Total Market Value – borrowed amount

Solvent FirmFirm with a positive net worth

Insolvent FirmFirm with a negative net worth- When assets are sold and debts are paid the owners

(stockholders) pay the priceIlliquid Firm

Has made long-term loans with borrowed funds ANDIs 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.

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 = Interest Rate and vice versa

LOANABLE FUNDS MARKET

LF USED FOR (DEMAND)• Business InvestmentInvestment• Government Budget Deficit• International InvestmentInvestment and

LendingQuantity of LF demandedDepends on: RIR and Expected ProfitFirms: Compare RIR with expected profit on new capital investment decisions

RIR = Qty LF demandedChanges in DLF (shifts)Happens when: Expected Profit Changes

Exp. Profit = amt. invested = 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 feelingsOptimism = Investment Pessimism = Investment


LF COME FROM (SUPPLY)• Private Savings (largest part)

• RIR• Disposable Income• Wealth• Expected Future income

• Government Budget Surplus• International BorrowingQuantity of LF suppliedDepends on: Mostly Savings depends on RIR, Disp.Inc., Wealth, Exp.Fut.Inc.Firms: Compare RIR with expected profit on new capital investment decisions

RIR = Savings = Qty LF supplied

Changes in SLF (shifts)• Disposable Income Disp. Inc. = savings• Wealth wealth = savings• Expected Future Income Exp.Fut.Inc. = savings• Default Risk Default Risk = savings


SHIFTS


Surplus, ShortageEffects of Shifts

GOVERNMENT in the LOANABLE FUNDS MARKET

GDP Y = C+I+G+NX; (Expenditure) [NX is 0 globally]GDP Y = C+S+NT; (Total Income)

C+I+G+NX = C+S+NTI+G = S+NTI = S+NT-G

Investment is financed by Private Savings and Govt. Savings

Total Savings = Private Savings + Govt. SavingsGovt. Surplus adds to private savingsGovt. Deficit takes away from private savings

decreases amount available for investment

SLF = PSLF + GSLF

SLF RIR qty private funds & qty investment and qty demand

GOVERNMENT in the LOANABLE FUNDS MARKET

Crowding-out-effectTendency for government budget deficit to raise the real interest rate and decrease investment

SURPLUS DEFICIT

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.

GOVERNMENT IN LOANABLE FUNDS MARKET

FORMULAS

NI = GI - Depreciation

Asset Price = Interest Rate

DLFRIR = Qty LF demanded Exp. Profit = amt. invested = DLFOptimism = Investment & Pessimism = Investment

SLFRIR = Savings = Qty LF supplied Disp. Inc. = savings wealth = savings Exp.Fut.Inc. = savings

SLF = PSLF + GSLF DLF = PDLF + GDLF

EYE on the PAST

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.

What Created the Global Financial Crisis?

EYE on FINANCIAL CRISIS

EYE on the PAST

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.



EYE on the PAST

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.



EYE on the U.S. ECONOMY

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.



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.



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.



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.

EYE on YOUR LIFE

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?

Your Participation in the Loanable Funds Market

EYE on YOUR LIFE

If you save a negative amount, just what does that mean?

It means that you have a deficit (like a government deficit). You’re 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?


EYE on YOUR LIFE

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?


Investment andCapital: 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.


Gross investment increases in most years and increased rapidly during the booming 1990s, but it decreases in recession years—see part (a) of the figure.

Recession years are highlighted in red.


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.

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.

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.

Interest Rate Puzzle

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Investment, Saving, and the Real Interest Rate