Investment, Savings, and Real Interest Rate.
Defns:
Physical capital : tools, instruments, machines, buildings,ect.
Financial capital is the funds that firms use to buy and operate
physical capital.
Gross investment is the total amount spent on new physical
capital goods.
Net investment is the change in the quantity of capital—equals
gross investment minus depreciation.
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.
Savings = income – taxes - consumption
PHYSICAL CAPITAL AND FINANCIAL CAPITAL
Concept: Savings is provided to firms in order to acquire physical
captial. This is done in these markets.
• Stock markets
• Bond markets
Ques: What are the differences between stocks and bonds?
Interest Rates.
Ques: Why do people charge an interest rate on loans?
Hint-Opportunity cost of lending
Concept: One Description of the Interest Rate on a Financial Asset.
The interest rate on a financial asset is a percentage of the price of the
asset.
Ex. Suppose one share entitled the owner to 40 cents. If on oct. 1 the
asset cost $40. what is the interest rate?
R=(.40/40)*100=1% Suppose the price of the asset fell to $20?
Here we see the inverse relationship between asset prices and the
interest rate.
Examples
1) Mark buys building and equipment for $400,000 in 2007. In 2008 he
sold for $100,000. How much is gross investment, depreciation, net
investment?
2) Becky earned $50,000, paid $6k in taxes and consumed $43 k worth
of goods. What is her Savings? Suppose she has $30,000 in her bank
account, what is her wealth?
3) Jeremy purchases a bond that pays $600 in interest. If Jeremy
paid$9,000 for the bond, what is the interest rate? If Jeremy paid
$10,000 for the bond, what is the interest rate? How did a rise in the
price of the bond affect the interest rate?
THE MARKET FOR LOANABLE FUNDS
Demand for loanable funds ( i.e stock, bond,ect)
1. Business investment
2. Government budget deficit
3. International investment or lending
Supply of loanable funds
1. Private saving
2. Government budget surplus
3. International borrowing
Demand for funds
The Demand for Loanable Funds
The quantity of loanable funds demanded depends on
1. The real interest rate
Firms borrow as long as real interest rate < expected profit.
ques: how is it analogous to labor demand?
If the nominal interest rate is 15% on a bank loan. And expected profit
on investment is 15%. For an inflation rate of 5% and a capital
investment of $1mil.
Calculate the expected real return on the investment.
AnsReal interest rate = 15%-5%=10%
Cost on investment = .10*$1 mil= $100k
Rev=$150K ….return = $150-$100=$50K
THE MARKET FOR LOANABLE FUNDS
Changes in the Demand for Loanable Funds
A change in expected profits Shifts the demand curve.
Whats the reasoning behind the shift??
Other shifters1) Larger population
2) Technological change
3) “animal spirits”
THE MARKET FOR LOANABLE FUNDS
Recall: The supply of loanable funds is the amount of funds available
from private saving, the government budget surplus, and
international borrowing
Ques: Why is the supply curve upward sloping? (Hint: the opportunity
cost of consumption).
Shifters
1. Disposable income (+)
2. Wealth (-)
3. Expected future income (-)
Recall: relate the price of funds to the
1) Opportunity cost of savings
2) Marginal benefit to borrowers
Questions
1) The Chinese buy a lot of U.S government securities. Describe
how this form of trade with the U.S is related to the U.S market for
loanable funds.
2) The market for loanable funds currently has an interest rate of 5%,
and $10Billion. Describe what happens in the market if
i)there is a global business boom, and firms expect their profits to
increase.
ii) Another world war begins, U.S against the world.
iii) If firms use loanable funds to finance capital purchases. Describe
what happens to Real GDP in each case.
GOVERNMENT IN LOANABLE FUNDS MARKET
Total saving equals private saving plus government saving.
Ques: Use a diagram to show how a government surplus/deficit
impact the the total supply of loanable funds? How is the real interest
rate and the total amount of funds impacted?
Concept: Crowding out effect: The increased interest rate and reduced
investment brought about by a government deficit.
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.
Why? People will increase savings due to expectations of higher
future taxes.
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.
Future value= $X * (1 + r)N