Transcript INVESTMENT, FINANCIAL INTERMEDIATION & FINANCIAL

Lecture 7
INVESTMENT, FINANCIAL
INTERMEDIATION
& FINANCIAL MARKETS
INVESTMENT
An action taken today that has costs
today but provides benefits in the
future.
• Firm building plant today incurs costs today but
earns revenue in the future
• Student incurs costs to attend university now for
the sake of higher earnings in the future
• Government spends money today to build a dam
to have a source of hydroelectric power in the
future
$$$
$$$
NOMINAL INTEREST RATES
Interest rates actually charged
in the market.
REAL INTEREST RATES
Nominal interest rates adjusted
for inflation.
FINANCIAL INTERMEDIARIES
Organizations that receive
funds from savers and channel
them to investors.
• financial institutions such as
banks, savings and loans, and
insurance companies
ANIMAL SPIRITS
John Maynard Keynes emphasized that
sharp swings in moods of investors were
often irrational and perhaps reflected our
most basic, primal instincts.
ACCELERATOR THEORY
One theory of investment spending that
emphasizes the role of expected growth in
real GDP on investment spending.
When real GDP growth is expected to be
high, firms anticipate that their investments
in plant and equipment will be profitable
and therefore increase their total
investment spending.
PROCYCLICAL
Increases during booms and falls
during recessions
• Investment spending is highly
procyclical
INVESTMENT IN STRUCTURES AND EQUIPMENT IN THE
EARLY 1990s
Billions of
1990 dollars
Billions of
1992 dollars
550
210
200
500
190
450
180
400
170
350
160
89
90
91
92
93
94
95
Year
Non-residential structures
89
90
91
92
93
94
95
Year
Producers’ durable Equipment
Source: Data from Economic Report of the President, Washington, DC:
U.S. Government Printing Office, yearly
MULTIPLIER-ACCELERATOR
MODEL
• In this model a downturn in real GDP would
lead to a sharp fall in investment, which, in
turn, would entail further reductions in GDP
through the multiplier for investment
spending.
BOND
A promise to pay money in
the future
NOMINAL INTEREST RATES
• Interest rates quoted in the market at
savings and loans or banks or for
bonds
• These are actual rates that
individuals or firms pay or receive
when they borrow money or lend
money
REALITY PRINCIPLE
What matters to people is
the real value or
purchasing power of
money or income, not its
face value.
REAL RATE OF INTEREST
• Nominal rate of interest minus
the inflation rate
Real rate = Nominal rate - inflation rate
EXPECTED REAL INTEREST RATE
The nominal rate minus the expected inflation rate.
Country
3-Month Interest
Rate
Australia
Belgium
Canada
Denmark
France
Germany
Italy
Japan
Spain
United States
8.12
5.13
7.86
6.95
7.80
4.65
11.00
1.36
9.28
6.08
Inflation Rate
over last 3
months
3.3
2.4
4.2
2.1
2.3
3.9
6.3
-1.7
7.9
3.3
Expected
real rate
of interest
4.82
2.73
3.66
4.85
5.50
0.75
4.70
3.06
1.38
2.78
Source : The Economist, April 29, 1995, pp122-23
TYPICAL INVESTMENT
0
Cost
-$100
TYPICAL INVESTMENT
Return
0
Cost
-$100
TYPICAL INVESTMENT
$104
Return
0
Cost
-$100
A typical investment, in which a cost of $100 incurred today yields a
return of $104 next year.
PRINCIPLE OF
OPPORTUNITY COST
The opportunity cost of something is what
you sacrifice to get it.
• Used to help decide whether to undertake
investment
• If the firm undertakes the investment, it
must give up $100 today to get $104 the
following year
• The interest rate provides a measure of the
opportunity cost of the investment
Real Rate of Interest
INTEREST RATES AND INVESTMENT
Investment Spending
As the real interest rate declines, investment spending in the
economy increases.
Real Rate of Interest
INTEREST RATES AND INVESTMENT
Investment Spending
As the real interest rate declines, investment spending in the
economy increases.
Real Rate of Interest
INTEREST RATES AND INVESTMENT
Investment Spending
As the real interest rate declines, investment spending in the
economy increases.
Real Rate of Interest
INTEREST RATES AND INVESTMENT
Investment Spending
As the real interest rate declines, investment spending in the
economy increases.
REAL INVESTMENT SPENDING
• Inversely related to the real interest rate
• Nominal interest rates are not necessarily a
good indicator of the true cost of investing
• Inflation would increase the nominal rate of
return and nominal interest rate equally
• A firm makes its investment decisions by
comparing its expected real net return from
investment projects to the real rate of
interest
NEOCLASSICAL THEORY
OF INVESTMENT
• Pioneered by Dale Jorgenson of Harvard
• Real interest rates and taxes play a key
role in determining investment spending
• Jorgenson used his theory to analyze the
responsiveness of investment to a variety
of tax incentives, including investment tax
credits that are subsidies to investment
Q-THEORY OF INVESTMENT
• Originally developed by Nobel laureate, James
Tobin of Yale University
• Theory states that investment spending increases
when stock prices are high
• If stock prices are high, it can issue new shares of
its stock at an advantageous price and use the
proceeds to undertake new investment
• Recent research has shown a close connection
between Q-theory and neoclassical theory and
highlighted the key role that real interest rates
and taxes play in the Q-theory as well
SOURCE OF INVESTMENT
SPENDING
• Investment spending in an economy
must ultimately come from savings
• When households earn income, they
consume part and save the rest
• These savings become the source of
funds for investment in the economy
LIQUIDITY
• Households want savings to be
readily accessible in case of
emergencies
• Funds deposited in a bank account
provide a source of liquidity for
households, since these funds can
be obtained at anytime
SAVERS AND INVESTORS
Savers
SAVERS AND INVESTORS
Savers
who face risk
Risk
Loss of Liquidity
costs of negotiation
SAVERS AND INVESTORS
Savers
who face risk
Risk
Demand
Loss of Liquidity High Interest
costs of negotiation
Rates
SAVERS AND INVESTORS
Savers
who face risk
Risk
Demand
Loss of Liquidity High Interest
costs of negotiation Rates from
Investors
FINANCIAL INTERMEDIARIES
• Institutions such as banks, savings and loans,
insurance companies, money market mutual
funds, and many other financial institutions
• Accept funds from savers and make loans to
businesses and individuals
• Pool funds of savers, reducing costs of
negotiation
• Acquire expertise in evaluating and monitoring
investments
• Some financial intermediaries, such as banks,
provide liquidity to households
DIVERSIFICATION
• Investing in a large number of
projects whose returns, although
uncertain, are independent of one
another
• How financial intermediaries reduce
risk
Financial Intermediaries
Savers
Investors
Financial Intermediaries
Savers
Financial
Intermediary
Bank
banks
savings and loans
insurance companies
Investors
Financial Intermediaries
Savers
Financial
Intermediary
Bank
make
deposits to
banks
savings and loans
insurance companies
Investors
Financial Intermediaries
Savers
Investors
Financial
Intermediary
Bank
make
deposits to
make
loans to
banks
savings and loans
insurance companies
FINANCIAL INTERMEDIATION MALFUNCTIONS
• Financial intermediation failures occurred for
banks in the USA during the Great Depression
and for savings and loans during the savings and
loan crises of the 1980s
• During the 1930s worried depositors and rumors
triggered runs on banks
• Since banks, as financial intermediaries, never
keep 100% of funds on hand, the runs closed
down thousands of healthy banks
• To prevent this from happening again, the U.S.
government began to provide deposit insurance
for banks and savings and loans
FINANCIAL INTERMEDIATION
MALFUNCTIONS
• Deposit insurance indirectly helped create
savings and loan crisis during the 1980s
• The government tried to assist the
(struggling) saving and loan industry by
reducing regulations
• Many investment projects collapsed and the
government was forced to bail out many
savings and loans at a cost of nearly $100
billion to the U.S. economy
Financial Markets
• Financial markets are financial institutions
through which savers can directly provide
funds to borrowers. In financial markets,
there is no “middle man”. The two most
important financial markets in the economy
are bond and stock markets.
Bond Market - 1
• Bonds are nothing more than an IOU. All
bonds contain specific information about
how much is being borrowed (the
principal), when the bond must be repaid
(the maturity date), and the rate of
interest that must be paid periodically
until the bond is repaid.
Bond Market - 2
• Bonds are issued by companies, as
well as the federal, state and local
governments, to raise money. When
a company or government issues a
bond, they are borrowing money.
When a person buys a bond, and
becomes a bondholder, that person
is the lender (or creditor).
Bond Market - 3
• Bonds are traded in markets where the
interaction of the demand and supply for
each type of bond determines that bonds
price. There are three important
characteristics that affect the value of all
bonds:
– the term (how long until the bond is due?);
– the credit risk (what is the probability that
the firm borrowing money will default?); and
– the tax treatment (is the interest paid on the
bond taxable by the federal government?).
Bond Market - 4
• Each of these three characteristics
determine the riskiness and profitability
of buying and holding a bond, and
therefore affect the demand for the bond.
As bonds become more risky, the
demand for the bond falls, and the bond
issuer must offer to pay a higher interest
rate to persuade people to purchase the
bond.
Bond Market - 5
• As bonds become more profitable,
the demand for the bond rises.
Because of this, tax free municipal
bonds pay low rates of interest.
Stock Markets - 1
• Issuing stock is another way for
firms
to
raise
money
(the
government cannot issue stock).
Whoever buys a firm’s stock
becomes a part owner of that firm.
Stock Markets - 2
• The money received by a firm from
issuing stock never needs to be repaid
(so stockholders are NOT creditors). Like
bonds, stock prices are determined in
markets by the interaction of the demand
and supply for each individual stock.
Stock Markets - 3
• Stock
prices
reflect
people’s
expectations about the firm’s future
profitability. When firms are expected
to be profitable, demand will be high,
and the stock price will rise. When
firms are expected to lose money,
demand will below, and the stock
price will fall.