Investment, Saving, and the Real Interest Rate

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Investment, Saving, and the Real Interest Rate
CHAPTER
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

• 1 Define and explain the relationships among
  capital, investment, wealth, and saving and
  describe the markets for financial capital.
• 2 Explain how investment and saving decisions
  are made and how these decisions interact in the
  market for loanable funds to determine the real
  interest rate and the amount of investment and
  saving.
• 3 Explain how government influences the real
  interest rate, investment, and saving.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Physical capital is 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 is the funds that firms use to
  buy and operate physical capital.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Investment and Capital
• Gross investment is the total amount spent on new
  capital goods.
• Net investment is the change in the quantity of
  capitalequals gross investment minus
  depreciation.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Figure 26.1 illustrates the relationship between
  capital and investment.

On January 1, 2008,Toms DVD Burning, Inc. had
DVD recording machines valued at 30,000.
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26.1 PHYSICAL CAPITAL AND FINANCIAL

• During 2008, the value of Tom machines falls by
  20,000, depreciation.

• He spent 30,000 on new machinesgross
• investment.

Toms net investment was 10,000, so at the end
of 2008,Tom had capital valued at 40,000.
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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Wealth and Saving
• Wealth is the value of all the things that a
  person owns.
• Saving is the amount of income that is not paid
  in taxes or spent on consumption goods and
  services saving adds to wealth.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Markets for Financial Capital
• Saving is the source of funds that are used to
  finance investment, and these funds are supplied
  and demanded by four groups of markets
• Stock markets
• Bond markets
• Short-term securities markets
• Loans markets

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Stock Markets
• Stock is a certificate of ownership and claim to
  the profits that a firm makes.
• Stock market is a financial market in which
  shares of companies stocks are traded.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Bond Markets
• Bond is a promise to pay specified sums of money
  on specified dates it is a debt for the issuer.
• Bond market is a financial market in which bonds
  issued by firms and governments are traded.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Short-Term Securities Markets
• Short-term securities are commercial bills and
  Treasury billspromises by large firms and
  government to pay an agreed sum 90 days in the
  future.
• Loans Markets
• Banks and other financial institutions lower the
  cost of financing firms capital expenditures by
  accepting short-term deposits and making
  longer-term loans.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Global Financial Markets
• Lending is risky. A loan might not be repaid. Or
  the price of a stock or bond might fall. The
  riskier the loan, other things being equal, the
  higher is the interest rate.
• For a given risk, lenders want to earn the
  highest possible real interest rate and they will
  look everywhere in the world to find the highest
  real interest rate.
• Borrowers want to pay the lowest possible real
  interest rate. So borrowers will look everywhere
  in the world to find the lowest real interest
  rate.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Because lenders are free to seek the highest real
  interest rate and borrowers are free to seek the
  lowest real interest rate, financial markets form
  a single, integrated, global market.
• The aggregate of all the individual financial
  markets is called the market for loanable funds.

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26.1 PHYSICAL CAPITAL AND FINANCIAL CAPITAL

• Interest Rates and Asset Prices
• Stocks, bonds, short-term securities, and loans
  are collectively called financial assets.
• The interest rate on a financial asset is a
  percentage of the price of the asset.
• So if the asset price rises, other things
  remaining the same, the interest rate falls.
• And conversely, if the asset price falls, other
  things remaining the same, the interest rate
  rises.

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26.2 THE MARKET FOR LOANABLE FUNDS

• Flows in the Market for Loanable Funds
• Loanable funds are used for
• 1. Business investment
• 2. Government budget deficit
• 3. International investment or lending
• Loanable funds come from
• 1. Private saving
• 2. Government budget surplus
• 3. International borrowing

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26.2 THE MARKET FOR LOANABLE FUNDS

• The Demand for Loanable Funds
• The quantity of loanable funds demanded depends
  on
• 1. The real interest rate
• 2. The expected profit
• The real interest rate is the opportunity cost of
  the funds used to finance the purchase of
  capital.
• So firms compare the real interest rate with the
  rate of profit that they expect to earn on their
  new capital.

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26.2 THE MARKET FOR LOANABLE FUNDS

• Firms invest only when they expect to earn a rate
  of profit that exceeds the real interest rate.
• The higher the real interest rate, the fewer
  projects that are profitable, so the smaller is
  the quantity of loanable funds demanded.
• The lower the real interest rate, the more
  projects that are profitable, so the larger is
  the quantity of loanable funds demanded.

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26.2 THE MARKET FOR LOANABLE FUNDS

• Demand for Loanable Funds Curve
• The demand for loanable funds curve is the
  relationship between the quantity of investment
  demanded and the real interest rate, other things
  remaining the same.
• The demand for loanable funds is shown by an
  demand for loanable funds schedule or curve.

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26.2 THE MARKET FOR LOANABLE FUNDS

• Figure 26.2 shows the demand for loanable funds.

The table and figure show the quantity of
loanable funds demanded at five real interest
rates.
Points A through E on the curve DLF correspond to
the rows in the table.
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26.2 THE MARKET FOR LOANABLE FUNDS
1. A rise in the real interest rate decreases the
quantity of loanable funds demanded.
2. A fall in the real interest rate increases the
quantity of loanable funds demanded.
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26.2 THE MARKET FOR LOANABLE FUNDS

• Changes in the Demand for Loanable Funds
• When the expected profit changes, the demand for
  loanable funds changes.
• Other things remaining the same, the greater the
  expected profit from new capital, the greater is
  the amount of investment and the greater is the
  demand of loanable funds .

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26.2 THE MARKET FOR LOANABLE FUNDS

• The many influences on expected profit can be
  placed in three groups
• Objective influences such as the phase of the
  business cycle, technological change, and
  population growth
• Subjective influences summarized in the phrase
  animal spirits
• Contagion effects summarized in the phrase
  irrational exuberance

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26.2 THE MARKET FOR LOANABLE FUNDS

• Figure 26.3 shows

1. An increase in expected profit increases
investment and shifts the demand for loanable
funds curve rightward to DLF1.
2. A decrease in expected profit decreases
investment and shifts the demand for loanable
funds curve leftward to DLF2.
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26.2 THE MARKET FOR LOANABLE FUNDS

• Supply of Loanable Funds
• The quantity of loanable funds supplied is the
  total funds available from private saving, the
  government budget surplus, and international
  borrowing during a given period.
• Saving is the main item and it depends on
• 1. The real interest rate
• 2. Disposable income
• 3. Wealth
• 4. Expected future income

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26.2 THE MARKET FOR LOANABLE FUNDS

• Other things remaining the same,
• The higher the real interest rate, the greater
  is the quantity of saving and the greater is the
  quantity of loanable funds supplied.
• The lower the real interest rate, the smaller is
  the quantity of saving and the smaller is the
  quantity of loanable funds supplied.

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26.2 THE MARKET FOR LOANABLE FUNDS

• The Supply of Loanable Funds Curve
• The supply of loanable funds is the relationship
  between the quantity of loanable funds supplied
  and the real interest rate when all other
  influences on lending plans remain the same.
• The real interest rate is the opportunity cost of
  consumption expenditure.
• A dollar spent is a dollar not saved, so the
  interest that could have been earned on that
  saving is forgone.

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26.2 THE MARKET FOR LOANABLE FUNDS
Figure 26.4 shows supply of loanable funds.
The table and figure show the quantity of
loanable funds supplied at five real interest
rates.
Points A through E on the curve correspond to the
rows in the table.
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26.2 THE MARKET FOR LOANABLE FUNDS
1. A rise in the real interest rate increases the
quantity of loanable funds supplied.
2. A fall in the real interest rate decreases the
quantity of loanable funds supplied.
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26.2 THE MARKET FOR LOANABLE FUNDS

• Changes in Supply of Loanable Funds
• The three main factors that influence saving and
  change the supply of loanable funds are
• 1. Disposable income
• 2. Wealth
• 3. Expected future income

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26.2 THE MARKET FOR LOANABLE FUNDS

• Disposable income is the income earned minus net
  taxes.
• Other things remaining the same,
• The greater a households disposable income, the
  greater is its saving.
• The greater a households wealth (what it owns),
  the less it will save.
• The higher a households expected future income,
  the smaller is its saving today.

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26.2 THE MARKET FOR LOANABLE FUNDS

• Shifts of the Supply of Loanable Funds Curve
• Along the supply of loanable funds curve, all the
  influences on saving other than the real interest
  rate remain the same.
• A change in any of these influences on saving
  changes saving and shifts the supply of loanable
  funds curve.

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26.2 THE MARKET FOR LOANABLE FUNDS

• Figure 26.5 shows a change in the supply of
  loanable funds.

1. The supply of loanable funds curve shifts
rightward from SLF0 to SLF1 if

• Disposable income increases

• Wealth decreases

• Expected future income decreases

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26.2 THE MARKET FOR LOANABLE FUNDS
2. The supply of loanable funds curve shifts
leftward from SLF0 to SLF2 if

• Disposable income decreases

• Wealth increases

• Expected future income increases

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26.2 THE MARKET FOR LOANABLE FUNDS

• Equilibrium in the Market for Loanable Funds
• Figure 26.6 shows how the real interest rate is
  determined.

• DLF is the demand for loanable funds curve
• SLF is the supply of loanable funds curve

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26.2 THE MARKET FOR LOANABLE FUNDS
1. If the real interest rate is 8 percent a
year, the quantity demanded is less than the
quantity supplied. There is a surplus of funds.
The real interest rate falls.
2. If the real interest rate is 4 percent a year,
the quantity demanded exceeds the quantity
supplied. There is a shortage of funds. The real
interest rate rises.
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26.2 THE MARKET FOR LOANABLE FUNDS
3. When the real interest rate is 6 percent a
year, the quantity of loanable funds demanded
equals the quantity supplied.
There is neither a shortage nor a surplus of
funds, and the real interest rate is at its
equilibrium level.
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26.2 THE MARKET FOR LOANABLE FUNDS

• Changes in Demand and Supply

1. If the demand for loanable funds increases,
the real interest rate rises.
2. If the supply of loanable funds increases, the
real interest rate falls.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• Government Budget and Government Saving

GDP is the sum of consumption expenditure C,
investment I, government expenditure 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 C, saving S, and net
taxes NT. That is, Y C S NT.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• Y C I G
• Y C S NT
• By combining these two equations
• C I G C S NT
• Subtract C and simplify the equation to
• I G S NT
• Now subtract G from both sides of this equation
  to obtain
• I S (NT G)

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• I S (NT G)
• This equation tells us that investment is
  financed by private saving S and government
  saving (NT G).
• Government saving (NT G) is also the government
  budget surplus.

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26.3 GOVERNMENT IN LOANABLE FUNDS 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.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• Effect of Government Saving
• A government budget surplus increases the supply
  of loanable funds.
• To find the supply of loanable funds, we must add
  the government budget surplus to private saving
  supply.
• An increase in the supply of loanable funds
  brings a lower real interest rate, which
  decreases the quantity of private funds supplied
  and increases the quantity of investment and the
  quantity of loanable funds demanded.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET
Figure 26.8 shows the effects of government
saving.
With balanced government budgets, the real
interest rate is 6 percent a year and the
quantity of loanable funds is 10 trillion a year.
1. A government budget surplus of 2 trillion is
added to private saving to determine the supply
of loanable funds curve SLF.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET
2. The real interest rate falls to 4 percent a
year.
3. The private supply of funds decreases to 9
trillion.
4. The quantity of loanable funds demanded and
investment increase to 11 trillion.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• Government Deficit and Crowding Out
• A government budget deficit works in the opposite
  way to the surplus.
• The total supply of loanable funds equals private
  saving minus the government budget deficit.
• But a decrease in the supply of loanable funds
  raises the real interest rate, which increases
  the quantity of private funds supplied.
• What happens to investment?

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• The tendency for a government budget deficit to
  raise the real interest rate and decrease
  investment is called the crowding-out effect.

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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET
Figure 26.8 shows a crowding-out effect.
With balanced government budgets, the real
interest rate is 6 percent a year and the
quantity of loanable funds is 10 trillion a
year. Private saving and investment are 10
trillion a year.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET
1. A government budget deficit is subtracted from
private saving to determine the total supply of
loanable funds curve SLF.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET
2. The real interest rate rises to 8 percent a
year.
3. Private saving increases to 11 trillion.
4. Total saving and investment decrease to 9
trillion.
Investment is crowded out.
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26.3 GOVERNMENT IN LOANABLE FUNDS MARKET

• 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.

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APPENDIX PRESENT VALUE

• Present value is the present value of a future
  sum of money is the amount that will earn enough
  interest to grow to that future sum.
• We calculate a present value by using a process
  called discounting.
• The easiest way to understand discounting is to
  begin with opposite, compoundingconverting a
  present sum to a future sum by earning interest.

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APPENDIX PRESENT VALUE

• Compounding and Future Value
• A future sum of money is equal to the present sum
  (present value) plus the interest which will
  accumulate in the future.
• Suppose you put 100 in a savings account that
  earns an interest rate of 10 percent a year.
• After 1 year, you will have 110 in the bank.
• After 2 years, you will have 110 plus 10 percent
  interest on 110, which is 121.

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APPENDIX PRESENT VALUE

• Future Value Formula
• When the interest rate is 10 percent a year (r
  0.1), 100 will accumulate as follows
• After 1 year 100 ? (1 r) 100 ? 1.1 110.
• After 2 years 100 ? (1 r)2 100 ? 1.21
  121.
• After N years 100 ? (1 r)N

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APPENDIX PRESENT VALUE

• Discounting and Present Value
• If the interest rate is 10 percent a year (r
  0.1) and you can have either 110 one year in the
  future or a different amount today, what is the
  amount youd accept?
• Youd accept the present value of 110.
• The present value of 110 is the amount if
  invested today at an interest rate of 10 percent
  a year will grow to 110 after one year.

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APPENDIX PRESENT VALUE

• 110 (Present value of 110) ? (1 0.1)
• So
• Present value of 110 110 ? (1 0.1) 100.
• Present Value Formula
• To calculate the present value of a future sum
• Present value Sum 1 year later ? (1 r).
• Present value Sum 2 years later ? (1 r)2.
• Present value Sum N years later ? (1 r)2.

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APPENDIX PRESENT VALUE

• The Crucial Roles of Time and the Interest Rate
• The present value of a future sum depends on
• How far in the future the money will be received
• The interest rate
• Shifting the time farther into the future lowers
  the present value.
• Raising the interest rate lowers the present
  value.
• Many decisions you make turn on present value,
  such as whether to pay off your credit card
  balance.