Transcript real interest rate

Macroeconomics: Principles, Applications, and Tools
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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O’Sullivan, Sheffrin, Perez
6/e.
Macroeconomics: Principles, Applications, and Tools
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
2 of 21
O’Sullivan, Sheffrin, Perez
6/e.
6/e.
O’Sullivan, Sheffrin, Perez
Macroeconomics: Principles, Applications, and Tools
Investment and
Financial Markets
After the end of the high tech
boom and the sharp decline in
the stock market in 2000,
individuals and firms began
looking for other areas to
invest and earn high returns.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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Macroeconomics: Principles, Applications, and Tools
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CHAPTER 12
Investment and
Financial Markets
APPLYING THE CONCEPTS
1
How do fluctuations in energy prices affect investment
decisions by firms?
Energy Price Uncertainty Reduces Investment
Spending
2
How can understanding the concept of present value
help a lucky lottery winner?
Options for a Lottery Winner
3
Why are there different types of interest rates in the
economy?
Interest Rates Vary by Risk and Length of Loan
4
How have recent financial innovations
created new risks for the economy?
Securitization: The Good, the Bad,
and the Ugly
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12.1
AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN
Macroeconomics: Principles, Applications, and Tools
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6/e.
CHAPTER 12
Investment and
Financial Markets
• accelerator theory
The theory of investment that says that current
investment spending depends positively on the
expected future growth of real GDP.
 FIGURE 12.1
Investment Spending as a
Share of U.S. GDP, 1970–2007
The share of investment
as a component of GDP
ranged from a low of
about 10 percent in 1975
to a high of over 18
percent in 2000.
The shaded areas
represent U.S. recessions.
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CHAPTER 12
Investment and
Financial Markets
APPLICATION
1
ENERGY PRICE UNCERTAINTY REDUCES
INVESTMENT SPENDING
APPLYING THE CONCEPTS #1: How do fluctuations in
energy prices affect investment decisions by firms?
One important way volatility of oil prices can hurt the economy is
by creating uncertainty for firms making investment decisions.
Consider whether a firm should invest in an energy-saving
technology for a new plant:
• If energy prices remain high, it may be profitable to
invest in energy-saving technology.
• If prices fall, these investments would be unwise.
• If future oil prices are uncertain, a firm may simply delay
building the plant until the path of oil prices are clear.
When firms are faced with an increasingly uncertain future, they
will delay their investment decisions until the uncertainty is
resolved.
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12.1
AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
• procyclical
Moving in the same direction as real GDP.
• multiplier-accelerator model
A model in which a downturn in real GDP
leads to a sharp fall in investment, which
triggers further reductions in GDP through
the multiplier.
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12.2
EVALUATING THE FUTURE
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
Understanding Present Value
PRESENT VALUE AND INTEREST RATES
• present value
The maximum amount a person is willing to pay today to
receive a payment in the future.
K
present value =
(1  i)t
P R I N C I P L E O F O P P O RT U N I T Y C O S T
The opportunity cost of something is what you sacrifice to get it.
1
2
3
The present value—the value today—of a given payment in the future is
the maximum amount a person is willing to pay today for that payment.
As the interest rate increases, the opportunity cost of your funds also
increases, so the present value of a given payment in the future falls. In
other words, you need less money today to get to your future “money goal.”
As the interest rate decreases, the opportunity cost of your funds also
decreases, so the present value of a given payment in the future rises. In
other words, you need more money today to get to your money goal.
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CHAPTER 12
Investment and
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APPLICATION
2
OPTIONS FOR A LOTTERY WINNER
APPLYING THE CONCEPTS #2: How can understanding the
concept of present value help a lucky lottery winner?
The lucky winner of a lottery was given an option:
• Receive $1 million a year for 20 years
• Receive $10 million today
Why would anyone take the $10 million today?
To determine which payment option is best, our
lottery winner would first need to:
• Calculate the present value of $1 million for each of
the 20 years
• Add up the result
• Compare it to the $10 million being offered to her today
Example: With an 8 percent interest rate, the present value of an
annual payment of $1 million every year for 20 years is $9.8 million.
Best option: If interest rates exceed 8 percent, it is better to take the $10 million dollars.
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12.2
EVALUATING THE FUTURE
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
Real and Nominal Interest Rates
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—the purchasing
power—not the face value of money.
• nominal interest rate
Interest rates quoted in the market.
• real interest rate
The nominal interest rate minus the inflation rate.
real rate  nominal rate  inflation rate
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12.2
EVALUATING THE FUTURE
Macroeconomics: Principles, Applications, and Tools
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CHAPTER 12
Investment and
Financial Markets
Real and Nominal Interest Rates
• expected real interest rate
The nominal interest rate minus
the expected inflation rate.
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CHAPTER 12
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APPLICATION
3
INTEREST RATES VARY BY RISK AND LENGTH OF LOAN
APPLYING THE CONCEPTS #3: Why are there different types of interest rates in the
economy?
 FIGURE 12.2
Interest Rates on Corporate
and Government Investments,
2002-2007
Riskier loans and loans for longer
maturities typically
have higher interest rates.
Notice that rates for corporate
bonds are higher than the rates
for 10-year Treasury bonds. The
reason is that corporations are
less likely to pay back their loans
than the U.S. government.
Notice, too, that for most of this
time period, the U.S. government
typically paid a lower rate when it
borrowed for shorter periods of
time (six months) than for longer
periods of time (10 years).
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12.3
UNDERSTANDING INVESTMENT DECISIONS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
 FIGURE 12.3
The Relationship between Real Interest
Rates, and Investment Spending
As the real interest rate declines,
investment spending in the economy
increases.
• neoclassical theory of investment
A theory of investment that says
both real interest rates and taxes
are important determinants of
investment.
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12.3
UNDERSTANDING INVESTMENT DECISIONS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
Investment and the Stock Market
• retained earnings
Corporate earnings that are not paid
out as dividends to their owners.
• corporate bond
A bond sold by a corporation to the
public in order to borrow money.
• Q-theory of investment
The theory of investment that links
investment spending to stock prices.
price of a stock = present value of expected future dividend payments
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12.3
UNDERSTANDING INVESTMENT DECISIONS
Macroeconomics: Principles, Applications, and Tools
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6/e.
CHAPTER 12
Investment and
Financial Markets
 FIGURE 12.4
The Stock Market and Investment
Levels, 1997–2003
Both the stock market and
investment spending rose
sharply from 1997, peaking in
mid-2000.
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12.4
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Investment and
Financial Markets
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• liquid
Easily convertible into money on short notice.
 FIGURE 12.5
Savers and Investors
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HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
12.4
• financial intermediaries
Organizations that receive funds from
savers and channel them to investors.
 FIGURE 12.6
Financial Intermediaries
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12.4
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
• securitization
The practice of purchasing loans, repackaging them, and selling them to
the financial markets.
• leverage
Using borrowed funds to purchase
assets.
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12.4
HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
When Financial Intermediaries Malfunction
• bank run
Panicky investors simultaneously
trying to withdraw their funds from
a bank they believe may fail.
• deposit insurance
Federal government insurance on
deposits in banks and savings
and loans.
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CHAPTER 12
Investment and
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APPLICATION
4
SECURITIZATION: THE GOOD, THE BAD, AND
THE UGLY
APPLYING THE CONCEPTS #4: How have recent financial
innovations created new risks for the economy?
As securitization developed, it allowed financial intermediaries to provide new
funds for borrowers to enter the housing market.
As the housing boom began in 2002, lenders and home purchasers began to
take increasing risks. Lenders made “subprime” loans to borrowers with
limited ability to actually repay their mortgages.
Some households were willing to take on considerable debt because they
were confident they could make money in a rising housing market. Lenders
securitized the subprime loans and financial firms offered exotic investment
securities to investors based on these loans. Many financial institutions
purchased these securities without really knowing what was inside them.
When the housing boom stopped and borrowers stopped making payments on
subprime loans, it created panic in the financial market. Effectively, through
securitization the damage from the subprime loans spread to the entire
financial market, causing a major crisis.
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KEY TERMS
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
CHAPTER 12
Investment and
Financial Markets
accelerator theory
neoclassical theory of investment
bank run
nominal interest rate
corporate bond
present value
deposit insurance
procyclical
expected real interest rate
Q-theory of investment
financial intermediaries
real interest rate
leverage
retained earnings
liquid
securitization
multiplier-accelerator model
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