Transcript Investment demand

Investment & Saving
Outline
•Physical versus financial capital
•Financial markets
•Theory of investment
•Investment demand
•The supply of savings
•Financial market equilibrium
•Effect of government saving
•The “crowding out” effect
–Physical capital
–The tools, instruments, machines, buildings,
and other constructions that have been
produced in the past and that are used to
produce goods and services.
–Financial capital
–The funds that firms use to buy and operate
physical capital.
Gross v. Net Investment: Again
• Capital and Investment
–Gross investment
–The total amount spent on new capital goods.
–Net investment
–The change in the quantity of capital—equals
gross investment minus depreciation.
Stock Markets
• Stock (Equity): A certificate
of ownership and claim to
the profits of a corporation.
• Stock Market: An
institution that facilitates
the transfer of stocks
among wealth holders.
Examples: NYSE, NASDAQ, London Stock
Exchange, Paris Bourse, Tokyo Stock
Exchange, Toronto Stock Exchange
Bond Markets
Bond
–A promise to pay specified sums of
money on specified dates; it is a debt
for the issuer.
–Bond market
–A financial market in which bonds
issued by firms and governments are
traded.
Firms issue new stocks or
bonds to raise the financial
capital necessary to
purchase new capital goods.
Theory of Investment
Why do firms
purchase things like
new offshore drilling
platforms, food
processing plants, or
bulldozers? Because
they expect they can
make a profit by
doing so.
Investment Function
Let
I  f ( , r )
Where:
•I is gross investment
• is the expected profit of investment; and
•r is the interest rate.
The Investment
Decision
Acquisition cost of a tractor–trailer rig . . . . . . . . $150,000.00
Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 years
Expected (extra) sales revenue per year
from the use of the asset . . . . . . . . . . . . . . . . . . $199,000.00
Expected costs per year to operate the asset . . $179,000.00
Diesel fuel
Driver salary & benefits
Repairs (including tires)
Misc. (fees, fines, etc.)
Depreciation
$37,000
68,000
19,000
5,000
50,000
Expected net sales revenue per year
from the use of the asset . . . . . . . . . . . . . . . . . . $20,000.00
Computing expected profit ()
To compute expected profit in percentage
terms:
Expected Net Sales Revenue Per Year

100
Acquisitio n Cost of the Capital Good
Thus we have:
$20,000

100  13.33%
$150,000
We would consider
the tractor-trailer rig
a sound investment if
the interest rate were
less than 13.33
percent.
– Investment demand
– The relationship between the quantity of
investment demanded and the interest rate,
other things remaining the same.
– Investment demand is shown by an
investment demand schedule or and
investment demand curve.
– As the interest rate decreases, more
investment projects become attractive in the
assessment of business decision-makers—
hence, the investment demand function is
downward-sloping with respect to the interest
rate.
What factors could cause
the investment demand
function to shift?
•Objective influences such as the
phase of the business cycle,
technological change, and population
growth
•Subjective influences summarized in the
phrase “animal spirits”
1. To have a more secure future, to start a
business, to finance a child’s education,
to satisfy miserliness, . . .
2. To earn interest.
We view interest as
the “reward for
saving” or the “reward
for postponing
gratification.”
Value of $1,000 in 3 years at
alternative interest rates
Interest rate Future value
4%
$1,127.27
5%
$1,161.47
6%
$1,196.68
7%
$1,232.93
8%
$1,270.24
9%
$1,308.65
10%
$1,348.18
11%
$1,388.88
12%
$1,430.77
The opportunity cost of
spending now
(measured in lost future
spending) is positively
related to the interest
rate.
GOVERNMENT IN THE
FINANCIAL MARKET
• Government Budget and Government
Saving
GDP is the sum of consumption expenditure, C;
investment, I; government purchases, G; and net
exports, NX.
In the global economy, net exports are zero, so for the
world as a whole:
Y=C+I+G
–GDP equals total income, which is the sum
of consumption expenditure, saving, S, and
net taxes, NT. So:
Y = C + S + NT
–By combining these two ways of looking at
GDP, you can see that:
C + I + G = C + S + NT
–Because consumption is on both sides of this
equation, we can subtract C and simplify the
equation to:
I + G = S + NT
–Now subtract government purchases from
both sides of this equation to obtain:
I = S + (NT – G)
–This equation tells us that investment is
financed by private saving and government
saving, NT – G.
–Government saving, NT – G, is also the
government budget surplus.
GOVERNMENT IN THE
FINANCIAL MARKET
–Total saving equals private saving plus
government saving.
–So when the government has a budget
surplus, it contributes toward financing
investment.
–But when the government has a budget
deficit, it competes with businesses for private
saving and decreases the amount available for
investment.
• Effect of Government Saving
–A government budget surplus increases total
saving supply.
–To find total saving supply, we must add the
government budget surplus to private saving
supply.
–An increase in saving supply brings a lower
interest rate, which decreases the quantity of
private saving supplied and increases the
quantity of investment.