Transcript Document

A Lecture Presentation
to accompany
Exploring Economics
3 Edition
by Robert L. Sexton
rd
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Printed in the United States of America
ISBN 0-324-26086-5
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Chapter 20
Investment and Saving
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20.1 Financial Markets
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How do households, businesses, and
government determine their levels of
investment and saving?
What role do financial markets play
in determining the quantity of capital
and the real interest rate?
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Financial Markets
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Financial markets facilitate the
interaction between households,
firms, governments, banks, and other
financial institutions that borrow and
lend funds.
In financial markets, households are
the suppliers of funds and firms are
the demanders.
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Government is a demander when it
is running a budget deficit and a
supplier when it is running a budget
surplus.
Banks and other financial institutions
coordinate the plans of lenders and
borrowers.
The interest rate is determined in
the financial markets.
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Financial markets are global.
The two most important financial
markets are:
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the stock market
the bond market
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Stocks
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The owners of corporations own
shares of stock in the company
and are called stockholders.
Each stockholder's ownership of the
corporation and voting rights in the
selection of corporate management
is proportionate to the number of
shares owned.
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Shares of stock are bought and sold
by individuals and institutions in the
stock market, usually on one of the
organized stock exchanges.
The price that shares sell for will
fluctuate (often many times a day)
with changes in demand and/or
supply.
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Corporations sometimes use proceeds
from new sales of stock to finance
expansion of their activities.
Two primary types of stock
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preferred stock
common stock
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Preferred stock
 Owners receive a fixed regular dividend
payment; the payment remains the same
regardless of the profits of the
corporation.
 No dividends can generally be paid to
holders of common stock until the
preferred stockholders receive a specified
fixed amount per share of stock, assuming
that funds are available after the debts of
the corporation are paid.
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Common stock

Owners are residual claimants.
Share in profits after expenses are paid,
including interest payments to debt
obligations and dividend payments to
preferred stock.
 If corporation is sold or liquidated, receive
assets after all debts are paid and preferred
stockholders are paid a fixed amount per
share.
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Dividends frequently vary with profits.
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Owners of common stock assume
greater risks than preferred
stockholders, doing so because the
potential rewards are then greater if
the company is in fact successful.
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Who Owns Stock In U.S.
Corporations?
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Individuals as well as institutions
such as insurance companies,
pension funds, mutual funds, trust
departments of banks, and university
and foundation endowment funds, all
hold corporate stocks.
General Motors, IBM, and Microsoft
have millions of individual
stockholders.
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
Indirectly, millions more are involved
in stocks through their interest in
mutual funds, ownership of life
insurance, vested rights in private
pension funds, and so on.
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Corporations obtain some of their
initial financial capital (dollars used to
buy capital goods) by selling stock.
Growth in the financial resources
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reinvesting profits that are earned in the
business
selling new shares of stock
borrowing money
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Bonds
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While corporate borrowing takes
different forms, corporations primarily
borrow by issuing bonds.
The holder of a bond is not a part
owner of a corporation; rather, he is a
creditor to whom the corporation has
a debt obligation.
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The obligation to bondholders is of
higher legal priority than that of
stockholders.
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Before any dividends can be paid, even
to owners of preferred stock, the interest
obligations to bondholders must be met.
If a company is liquidated, bondholders
must be paid in full the face value of
their bond holding before any
disbursements can be made to
stockholders.
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Bondholders have greater financial
security than stockholders, but
receive a fixed annual interest
payment, with no possibility to
receive increased payments as the
company prospers.
The possibility of the value of a bond
increasing greatly—a capital gain—is
limited compared to that of stocks.
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A company can get finances through
plowbacks or reinvestment.
Instead of using their profits to pay
out dividends, a firm might take some
of its profits and plow it back into the
company for new capital equipment.
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Refinancing is by far the most
important source of funding—almost
65 percent of a firm’s finances come
from reinvestment.
Attractive to firms as a source of
funds because issuing new stocks and
bonds can be an expensive and
lengthy process.
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The Stock Market
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The two most important financial
markets where savers can provide
funds to borrowers are the stock
market and the bond market.
The values of securities (stocks and
bonds) sold in financial markets
change with expectations of benefits
and costs.
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Expected corporate earnings,
business conditions, the economic
policies of the government, business
conditions in foreign countries, and
concern over inflation all influence
the price of stocks (and, to a lesser
extent, bonds).
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During periods of rising securities
markets, optimism is generally great,
and businesses are more likely to
invest in new capital equipment,
perhaps financing it by selling new
shares of stock at current high prices.
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During periods of pessimism, stock
prices fall, and businesses reduce
expenditures on new capital equipment,
partly because financing such equipment
by stock sales is more costly.
More shares have to be sold to get a
given amount of cash, seriously diluting
the ownership interest of existing
stockholders.
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Economists consider the stock market
a random walk.

Without illegal inside information or a lot
of luck, it is very difficult to consistently
pick winners in the stock market.
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Hot tips are only hot if you are one of
only a few to know if a company's stock
is going to rise.
Once that news hits the street, it will
cease to be a source of profit.
In sum, if markets are operating
efficiently, the current stock prices will
reflect all available information, and
consistent, extraordinary profit
opportunities will not exist.
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Many financial analysts think that
the best stock market strategy is to
diversify, buying several different
stocks, and holding them for long
periods.
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You don't have to continue to pay
commissions on additional trades.
The stock market has historically
outperformed other financial assets.
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Reading Stock Tables
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Most newspapers (and many Web sites)
have a financial section that covers the
prices of stocks so investors can have
some of the information that they need
to make their decisions to buy and sell
stocks.
Some investors watch this data by the
second as they are trading in and out of
stocks a number of times during the
day.
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At the other extreme, some investors
pick a good company and hold the
stock for a long time hoping that it
will give them a better return than
other assets, like saving accounts.
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Wall Street Journal’s stock tables
explained:
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First column shows the stock’s year-todate percentage change
Second column shows highest price over
the last 52 weeks.
Third column shows the stock’s lowest
price over the last 52 weeks.
Fourth column shows the name and
symbol of the stock.
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Fifth column shows the dividend
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annual amount the company has paid over
the preceding year on each share of stock.
Sixth column shows the yield, the dividend
divided by the price of the stock.
Seventh column shows the price-earnings
(PE) ratio

price of the stock divided by the amount the
company earned per share over the past
year.
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Price earnings ratio--measure of
how highly a stock is valued.
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Typical price earnings ratio is around 15.
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If higher, the stock is relatively expensive in
terms of its recent earnings.
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The stock might be overvalued or
investors are expecting share prices to rise in the
future.
If lower, the stock is either undervalued or
investors may expect future earnings to fall.
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Eighth column shows the previous trading
day’s high for the stock.
Ninth column shows the previous trading
day’s low for the stock.
Tenth column shows the previous trading
day’s closing price for the stock.
Eleventh column shows the net change in
the stock price during the previous trading
day.
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20.2 Investment Demand and
Saving Supply
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If we put the investment demand for
the whole economy and national
savings together, we can establish
the real interest rate in the saving
and investment market.
The investment demand curve (ID) is
downward sloping, reflecting the fact
that investment spending varies
inversely with the real interest rate—the
amount borrowers pay for their loans.
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At high real interest rates, firms will
only pursue those few investment
activities with even higher expected
rates of return.
As the real interest rate falls,
additional projects with lower
expected rates of return become
profitable for firms, and the quantity
of investment demanded rises.
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The investment demand curve shows
the dollar amount of investment
forthcoming at different real interest
rate.
Because lower interest rates stimulate
the quantity of investment
demanded, governments often try to
combat recessions by lowering
interest rates.
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Shifting The Investment
Demand Curve
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For a given interest rate,
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If firms expect higher rates of return on
their investments, the ID curve will shift
to the right.
If firms expect lower rates of return on
their investments, the ID curve will shift
to the left.
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Several determinants other than
interest rates will shift the investment
demand curve.
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technology
inventory
expectations
business taxes
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Product and process innovation can
cause the ID curve to shift out.
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The development of new machines that
can improve the quality and the quantity
of products or lower the costs of
production will increase the rate of return
on investment, independent of the
interest rate. The same is true for new
products.
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Inventories are high.
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goods are stockpiled in warehouses
lower expected rate of return on new
investment,
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Firms with excess inventories of finished
goods have little incentive to invest in new
capital.
so ID shifts to the left.
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Inventories are low.
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firms look to replenish their shelves
expected rate of return on new
investment increases
so ID shifts to the right.
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If higher expected sales and a higher profit
rate are forecast, firms will invest in plant
and equipment and the ID curve shifts to
the right.
 More investment will be desired at a
given interest rate.
If lower expected sales and a lower profit
rate are forecasted, the ID curve shifts to
the left.
 Fewer investments will be desired at a
given interest rate.
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
If business taxes are lowered,
potential after-tax profits on
investment projects will increase and
shift the ID curve to the right.
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such as with an investment tax credit,
Higher business taxes will lead to
lower potential after-tax profits on
investment projects and shift the ID
curve to the left.
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The supply of national saving is
composed of both private saving and
public saving.
 Households, firms, and the
government can supply savings.
The supply curve of savings is upward
sloping.
At a higher real interest rate, there is a
greater quantity of savings supplied.
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Think of the interest rate as the
reward for saving and supplying funds
to financial markets.
At a lower real interest rate, a lower
quantity of savings is supplied.
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
If disposable (after-tax) income
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rises, the supply of savings shifts to the
right; more savings would occur at any
given interest rate.
falls, the supply of savings shifts to the
left; less saving would occur at any given
interest rate.
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As with the investment demand curve,
there are noninterest determinants of the
saving supply curve.
Expected future earnings
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lower, you would tend to save more now at any
given interest rate shifting the saving supply
curve to the right.
higher, you would tend to consume more and
save less now, knowing that more income is
right around the corner shifting the saving
supply curve to the left.
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In equilibrium,
 desired investment equals desired national
saving at the intersection of the investment
demand curve and the saving supply curve.
 The real equilibrium interest rate is
determined by the intersection of these
two curves.
If the real interest rate is above the
equilibrium real interest rate, forces within
the economy would tend to restore the
equilibrium.
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At a higher than real equilibrium interest
rate, the quantity of savings supplied
would be greater that quantity of
investment demanded; there would be a
surplus of savings at this real interest
rate.
As savers (lenders) compete against
each other to attract investment
demanders (borrowers), the real
interest rate falls.
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Alternatively if the real interest rate is
below the equilibrium real interest rate,
the quantity of investment demanded
is greater than the quantity of saving
supplied at that interest rate and a
shortage of saving occurs.
As investment demanders (borrowers)
compete against each other for the
available saving, the real interest rate
is bid up.
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Calculating Present Value
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One of the most important decisions
a firm makes is investment in new
capital.
A lot of money will be invested in
factory equipment and machines
expected to last for many years.
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A firm making an investment decision
must consider the price of the new capital
that they must pay now with the
additional revenue the firm anticipates
to make over time.
That is, the firm must compare current
cost with future benefits.
To figure out how much those future
benefits are worth today, economists
use a concept called present value.
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The present value of future income
is the value of having that future
income now.
People prefer to have money now
rather than later; that is why they are
willing to pay interest to borrow it.
PV = $X / (1 + r)t
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Because the discount rate varies from
person to person, a good proxy is the
market rate of interest.
An investor will buy capital if the
expected discounted present value of
the capital exceeds the current price.
Therefore, falling interest rates lead
to greater investment.
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Government And Financial
Markets
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We have treated the labor, capital,
and land markets independently.
In reality, these markets are
interdependent.
For example, if wages rise and/or the
rental price of capital falls, machines
might be substituted for some
workers.
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Total output of firms equals the total
income of households.
GDP (or Y) = C + I + G + (X – M)
In a closed economy, net imports
are zero because there is no
international trade—that is, exports
are zero and imports are zero.
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(1)
(2)
(3)
(4)
(5)
Y=C+I+G
Y–C -G=I
S=I
S=Y–C–G
S = (Y – T – C) + (T – G)
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Private saving is the amount of
income households have left over
after consumption and net taxes.
Public saving is the amount of
income the government has left
over after paying for its spending.
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
Let’s see how a budget surplus affects
the real interest rate and the amount
of saving and investment.
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
When the government spends more
than it receives in tax revenues, it
experiences a budget deficit; the
government is actually dissaving
(saving negatively or borrowing),
which decreases national saving.
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When the real interest rate rises
because of the government budget
deficit, private investment decreases.
Economists call this the crowdingout effect.
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Saving And Investment In An
Open Economy
 In an open economy, individuals,
firms, and governments are able to
borrow from and lend to foreigners.
 When foreigners supply more funds
than they demand, there is a capital
inflow.
 When foreigners demand more funds
than they supply, there is a capital
outflow.
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Copyright © 2002 by Thomson Learning, Inc.

Capital outflows to foreign countries
reduce the saving supply, reducing
the funds available for domestic
capital investment and causing the
saving supply curve to be positioned
to the left of the national saving
supply curve.
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When the real domestic interest rate
is low, capital will flow out to foreign
markets where the real interest rate
is higher.
A higher real domestic interest rate
will cause an inflow of capital because
foreigners will look for a higher rate
of return on their investments.
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