1. Capital Markets
Savings, Investment, and Interest
Rates
www.StudsPlanet.com

2. Some Useful Terminology
• Savings: Current income which is deferred for future
consumption (i.e., not spent)
www.StudsPlanet.com

3. Some Useful Terminology
• Savings: Current income which is deferred for future
consumption (i.e., not spent)
National Income: $8,512.3 B
+ Dividend Payments, Interest, Gov’t Transfers, etc.: $582.5B
- Taxes: $1,077.2 B
= Personal Disposable Income: $8,017.6 B
- Personal Consumption Expenditures: $7,727.2 B
= Personal Savings: $290.4B (3.5% of Personal Income)
www.StudsPlanet.com

4. Some Useful Terminology
• Savings: Current income which is deferred for future
consumption (i.e., not spent)
National Income: $8,512.3 B
+ Dividend Payments, Interest, Gov’t Transfers, etc.: $582.5B
- Taxes: $1,077.2 B
= Personal Disposable Income: $8,017.6 B
- Personal Consumption Expenditures: $7,727.2 B
= Personal Savings: $290.4B (3.5% of Personal Income)
• Note that there are many ways to save (savings account,
bonds, stocks, etc.)
www.StudsPlanet.com

5. Some Useful Terminology
• Investment: The purchase of new capital goods.
www.StudsPlanet.com

6. Some Useful Terminology
• Investment: The purchase of new capital goods.
– Gross Investment: Total purchases of new capital goods
www.StudsPlanet.com

7. Some Useful Terminology
• Investment: The purchase of new capital goods.
– Gross Investment: Total purchases of new capital goods
• Gross Private Investment: $1,611.2 B
• Gross Public Investment: $355 B
www.StudsPlanet.com

8. Some Useful Terminology
• Investment: The purchase of new capital goods.
– Gross Investment: Total purchases of new capital goods
• Gross Private Investment: $1,611.2 B
• Gross Public Investment: $355 B
– Net Investment: Gross investment less depreciation of existing
capital (capital consumption)
• Net Private Investment: $500 B
• Net Public Investment: $250 B
www.StudsPlanet.com

9. NIPA Accounts
• Recall, the accounting identity in the NIPA accounts:
GDP = C + I + G + NX
www.StudsPlanet.com

10. NIPA Accounts
• Recall, the accounting identity in the NIPA accounts:
GDP = C + I + G + NX
• GDP = Gross Private Savings + Taxes + C
www.StudsPlanet.com

11. NIPA Accounts
• Recall, the accounting identity in the NIPA accounts:
GDP = C + I + G + NX
• GDP = Gross Private Savings + Taxes + C
Gross Private Savings = I + (G-T) + NX
I (Public + Private) : $1,966 B
+ (G-T): $106B
+ NX: - $559B
Gross Private Savings: $1,513B (16% of GDP)
www.StudsPlanet.com

12. NIPA Accounts
• Recall, the accounting identity in the NIPA accounts:
GDP = C + I + G + NX
• GDP = Gross Savings + Taxes + C
I + (G-T) + NX = Gross Private Savings
I (Public + Private) : $1,966 B
+ (G-T): $123B
+ NX: - $487B
Gross Private Savings: $1,513B
Personal Savings ($290B) = Gross Private Saving ($1,513B) - Depreciation
www.StudsPlanet.com

13. Interest Rates
• What is an interest rate?
www.StudsPlanet.com

14. Interest Rates
• What is an interest rate?
– The interest rate is the relative price of current
spending in terms of foregone future income.
www.StudsPlanet.com

15. Interest Rates
• What is an interest rate?
– The interest rate is the relative price of current
spending in terms of foregone future income.
– Example: if the interest rate is 5% (Annual),
you must give up $1.05 worth of next year’s
income in order to increase this year’s spending
by $1.
www.StudsPlanet.com

16. Interest Rates:1987-2003
0
1
2
3
4
5
6
7
8
9
10
1/1/87
1/1/89
1/1/91
1/1/93
1/1/95
1/1/97
1/1/99
1/1/01
1/1/03
3 Mo. T-Bill
www.StudsPlanet.com

17. Interest Rates:1987-2003
0
1
2
3
4
5
6
7
8
9
10
1/1/87
1/1/89
1/1/91
1/1/93
1/1/95
1/1/97
1/1/99
1/1/01
1/1/03
3 Mo. T-Bill
10 Year T-Note
www.StudsPlanet.com

18. The Yield Curve
www.StudsPlanet.com

19. Yield Curves
• What determines the shape of the yield
curve?
– Segmented Markets Hypothesis
– Expectations Hypothesis
– Preferred Habitat Hypothesis
www.StudsPlanet.com

20. Interest Rates:1987-2003
0
2
4
6
8
10
12
1/1/87
1/1/89
1/1/91
1/1/93
1/1/95
1/1/97
1/1/99
1/1/01
1/1/03
3 Mo. T-Bill
10 Year T-Note
AAA Corp.
www.StudsPlanet.com

21. Interest Rates
• Treasury Securities (1 - 5%)
• Agency Securities (1 - 5%)
• Municipal Bonds (3 – 5%)
• Corporate Bonds (6 – 11%)
• Preferred Stock (5 – 15%)
• Asset Backed Securities (4 – 5%)
www.StudsPlanet.com

22. Interest Rates
• Treasury Securities (1 - 5%)
• Agency Securities (1 - 5%)
• Municipal Bonds (3 – 5%)
• Corporate Bonds (6 – 11%)
• Preferred Stock (5 – 15%)
• Asset Backed Securities (4 – 5%)
• “Risky” Rate = Risk Free Rate + Risk Premium
www.StudsPlanet.com

23. Real vs. Nominal Interest Rates
• As with any other variable, the nominal interest rate is in
terms of dollars. (the cost of a current dollar in terms of
forgone future dollars). To calculate the real interest rate,
we need to correct for the purchasing power of those
dollars.
www.StudsPlanet.com

24. Real vs. Nominal Interest Rates
• As with any other variable, the nominal interest rate is in
terms of dollars. (the cost of a current dollar in terms of
forgone future dollars). To calculate the real interest rate,
we need to correct for the purchasing power of those
dollars.
• Exact: (1+i ) = (1+ r )*(1 + inflation rate)
www.StudsPlanet.com

25. Real vs. Nominal Interest Rates
• As with any other variable, the nominal interest rate is in
terms of dollars. (the cost of a current dollar in terms of
forgone future dollars). To calculate the real interest rate,
we need to correct for the purchasing power of those
dollars.
• Exact: (1+i ) = (1+ r )*(1 + inflation rate)
• Approximation: i = r + inflation rate
www.StudsPlanet.com

26. Real/Nominal Interest Rates
-10
-5
0
5
10
15
20
1/1/19651/1/19681/1/19711/1/19741/1/19771/1/19801/1/19831/1/19861/1/19891/1/19921/1/19951/1/19981/1/2001
Inflation
Real
Nominal
www.StudsPlanet.com

27. Real vs. Nominal Interest Rates
• As with any other variable, the nominal interest rate is in
terms of dollars. (the cost of a current dollar in terms of
forgone future dollars). To calculate the real interest rate,
we need to correct for the purchasing power of those
dollars.
• Exact: (1+i ) = (1+ r )*(1 + inflation rate)
• Approximation: i = r + inflation rate
• How can real interest rates be negative?
www.StudsPlanet.com

28. Real vs. Nominal Interest Rates
• As with any other variable, the nominal interest rate is in
terms of dollars. (the cost of a current dollar in terms of
forgone future dollars). To calculate the real interest rate,
we need to correct for the purchasing power of those
dollars.
• Exact: (1+i ) = (1+ r )*(1 + inflation rate)
• Approximation: i = r + inflation rate
• How can real interest rates be negative?
– Ex ante vs. ex post
www.StudsPlanet.com

29. Present Value
• With a positive interest rate, income received in the future
is less valuable that income received immediately.
www.StudsPlanet.com

30. Present Value
• With a positive interest rate, income received in the future
is less valuable that income received immediately.
• At a 5% annual interest rate, $1.05 to be received in one
year is equivalent to $1 to be received today (because $1
today could be worth $1.05)
$1(1.05) = $1.05
www.StudsPlanet.com

31. Present Value
• With a positive interest rate, income received in the future
is less valuable that income received immediately.
• At a 5% annual interest rate, $1.05 to be received in one
year is equivalent to $1 to be received today (because $1
today could be worth $1.05)
$1(1.05) = $1.05
• Therefore, the present value of $1.05 to be paid in one year
(if the annual interest rate is 5%) is $1.
www.StudsPlanet.com

32. Present Value
• With a positive interest rate, income received in the future
is less valuable that income received immediately.
• At a 5% annual interest rate, $1.05 to be received in one
year is equivalent to $1 to be received today (because $1
today could be worth $1.05)
$1(1.05) = $1.05
• Therefore, the present value of $1.05 to be paid in one year
(if the annual interest rate is 5%) is $1.
• In general, the PV of $X to be paid in N years is equal to
PV = $X/(1+i)^N
www.StudsPlanet.com

33. Income vs. Wealth
• Your wealth is defined and the present value of your
lifetime income.
www.StudsPlanet.com

34. Income vs. Wealth
• Your wealth is defined and the present value of your
lifetime income.
• For example, suppose you expect your annual income to
be $50,000 per year for the rest of your life. If the annual
interest rate is 3%:
Wealth = $50,000 + $50,000/(1.03) + $50,000/(1.03)^2 + ……
= $50,000/(.03) = $1,666,666 (Approx)
www.StudsPlanet.com

35. Household Savings
• Without an active capital markets,
household consumption is restricted to
equal current income (that is, C=Y)
www.StudsPlanet.com

36. Household Savings
• Without an active capital markets,
household consumption is restricted to
equal current income (that is, C=Y)
• With capital markets, the present value of
lifetime consumption must equal the present
value of lifetime income (assuming all debts
are eventually repaid)
www.StudsPlanet.com

37. A two period example
• Suppose that your current income is equal
to $50,000 and you anticipate next year’s
income to be $60,000. The current interest
rate is 5%.
www.StudsPlanet.com

38. A two period example
• Suppose that your current income is equal
to $50,000 and you anticipate next year’s
income to be $60,000. The current interest
rate is 5%.
• In the absence of capital markets, your
consumption stream would be $50,000 this
year and $60,000 next year.
www.StudsPlanet.com

39. Consumption Possibilities
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Current Consumption (000s)
FutureConsumption(000s)
www.StudsPlanet.com

40. Borrowing to increase current consumption
• To increase your current consumption, you
could take out a loan. Your current
consumption would now be
C = $50,000 + Loan
www.StudsPlanet.com

41. Borrowing to increase current consumption
• To increase your current consumption, you could
take out a loan. Your current consumption would
now be
C = $50,000 + Loan
• However, you must repay your loan next year.
This implies that
C’= $60,000 – (1.05)Loan
www.StudsPlanet.com

42. Borrowing to increase current consumption
• To increase your current consumption, you could take out
a loan. Your current consumption would now be
C = $50,000 + Loan
• However, you repay your loan next year. This implies that
C’= $60,000 – (1.05)Loan
• For example, if you take out a $10,000 loan, your current
consumption would be $60,000, while your future income
would be $60,000 - $10,000(1.05) = $49,500
www.StudsPlanet.com

43. Consumption Possibilities
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

44. Borrowing Limits
Note that you need to be able to repay your
loan next year. Therefore,
$60,000 > (1.05)Loan
www.StudsPlanet.com

45. Borrowing Limits
• Note that you need to be able to repay your
loan next year. Therefore,
$60,000 = (1.05)Loan
• Your maximum allowable loan is
$60,000/1.05 = $57,143 (this is associated
with zero future consumption)
www.StudsPlanet.com

46. Borrowing Limits
• Note that you need to be able to repay your
loan next year. Therefore,
$60,000 = (1.05)Loan
Your maximum allowable loan is
$60,000/1.05 = $57,143 (this is associated
with zero future consumption)
Therefore, your maximum current
consumption is $107,143
www.StudsPlanet.com

47. Consumption Possibilities
0
20
40
60
80
100
120
0 10 20 30 40 50 60 70 80 90 100 110 120
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

48. Consumption Possibilities
0
20
40
60
80
100
120
0 10 20 30 40 50 60 70 80 90 100 110 120
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

49. Saving to increase future consumption
• You could increase future consumption by saving some of
your income (i.e. a negative loan). Suppose you put
$20,000 in the bank, your current consumption is now
$30,000.
www.StudsPlanet.com

50. Saving to increase future consumption
• You could increase future consumption by saving some of
your income (i.e. a negative loan). Suppose you put
$20,000 in the bank, your current consumption is now
$30,000.
• Next year, your bank account will be worth $20,000(1.05)
= $21,000. Therefore, your future consumption will be
$81,000
www.StudsPlanet.com

51. Consumption Possibilities
0
20
40
60
80
100
120
0 10 20 30 40 50 60 70 80 90 100 110 120
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

52. Maximizing future consumption
• Suppose you save your entire income. Your
current consumption will be zero, but your
future consumption will be
C’ = $60,000 + $50,000(1.05) = $112,500
www.StudsPlanet.com

53. Consumption Possibilities
0
20
40
60
80
100
120
0 10 20 30 40 50 60 70 80 90 100 110 120
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

54. Consumption Possibilities
0
20
40
60
80
100
120
0 10 20 30 40 50 60 70 80 90 100 110 120
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

55. Suppose that the interest rate rises to 8%
• Note that if you don’t borrow or lend, you
are unaffected.
www.StudsPlanet.com

56. Suppose that the interest rate rises to 8%
• Note that if you don’t borrow or lend, you are
unaffected.
• At higher interest rates, your borrowing limit falls:
Loan = $60,000/1.08 = $55,556 (higher interest
rates are bad for borrowers)
www.StudsPlanet.com

57. Suppose that the interest rate rises to 8%
• Note that if you don’t borrow or lend, you
are unaffected.
• At higher interest rates, your borrowing
limit falls: Loan = $60,000/1.08 = $55,556
(higher interest rates are bad for borrowers)
• However, if you are saving, you receive
more interest: $50,000(1.08) = $54,000
(higher interest rates are good for savers)
www.StudsPlanet.com

58. Consumption Possibilities
Current Consumption (000s)
FutuerConsumption(000s)
www.StudsPlanet.com

59. Consumption Possibilities
Current Consumption (000s)
FutureConsumption(000s)
www.StudsPlanet.com

60. The interest rate is the relative price of current consumption
in terms of future consumption
• When any relative price changes, there are
two distinct effects that impact consumer
behavior
www.StudsPlanet.com

61. The interest rate is the relative price of current consumption
in terms of future consumption
• When any relative price changes, there are two distinct
effects that impact consumer behavior
– The substitution effect: as relative prices change, consumer
typically alter purchases to favor the good that has become
cheaper
www.StudsPlanet.com

62. The interest rate is the relative price of current consumption
in terms of future consumption
• When any relative price changes, there are two distinct
effects that impact consumer behavior
– The substitution effect: as relative prices change, consumer
typically alter purchases to favor the good that has become
cheaper
– Income Effect: Changing prices alter one’s purchasing power.
When purchasing power falls/rises, purchases fall/rise
www.StudsPlanet.com

63. How does rising interest rates influence savings
decisions?
www.StudsPlanet.com

64. How does rising interest rates influence savings
decisions?
• The substitution effect is unambiguous: as interest
rates rise, current consumption becomes more
expensive. Therefore, consumers spend less (i.e.
save more)
www.StudsPlanet.com

65. How does rising interest rates influence savings
decisions?
• The substitution effect is unambiguous: as interest
rates rise, current consumption becomes more
expensive. Therefore, consumers spend less (i.e.
save more)
• The income effect depends on your current
situation: borrowers experience a negative income
effect and therefore would spend less (save more)
while savers experience a positive income effect
and therefore would spend more (save less)
www.StudsPlanet.com

66. Impact of rising interest rates
Borrowers
• Substitution effect:
spend less (save more)
• Income effect: Spend
less (save
more)___________
Net effect: Save More
Savers
• Substitution effect:
spend less (save more)
• Income effect: spend
more (save
less)___________
Net effect: ????
www.StudsPlanet.com

67. Aggregate Savings
• At the individual level, we would need to consider income
and substitution effects to determine the precise impact of
rising/falling interest rates on savings behavior
www.StudsPlanet.com

68. Aggregate Savings
• At the individual level, we would need to consider income
and substitution effects to determine the precise impact of
rising/falling interest rates on savings behavior
• At the aggregate level, new savings is very close to zero
(i.e., there are approximately the same number of
borrowers as there are lenders
www.StudsPlanet.com

69. Aggregate Savings
• At the individual level, we would need to consider
income and substitution effects to determine the
precise impact of rising/falling interest rates on
savings behavior
• At the aggregate level, new savings is very close
to zero (i.e., there are approximately the same
number of borrowers as there are lenders
• Therefore, the income effects cancel out and
higher interest rates have an unambiguous positive
effect on savings
www.StudsPlanet.com

70. Aggregate Savings
0
1
2
3
4
5
6
7
8
9
0 10 20 30 40 50
Savings ($)
InterestRate(%)
www.StudsPlanet.com

71. Again, assume that the interest rate is 5%, consider
two individuals
Person A
• Current income:
$10,000
• Anticipated future
income: $50,000
www.StudsPlanet.com

72. Again, assume that the interest rate is 5%, consider
two individuals
Person A
• Current income:
$10,000
• Anticipated future
income: $50,000
Person B
• Current Income:
$50,000
• Anticipated Future
income: $8,000
www.StudsPlanet.com

73. Again, assume that the interest rate is 5%, consider
two individuals
Person A
• Current income:
$10,000
• Anticipated future
income: $50,000
Wealth: $57,619
Person B
• Current Income:
$50,000
• Anticipated Future
income: $8,000
www.StudsPlanet.com

74. Again, assume that the interest rate is 5%, consider
two individuals
Person A
• Current income:
$10,000
• Anticipated future
income: $50,000
Wealth: $57,619
Person B
• Current Income:
$50,000
• Anticipated Future
income: $8,000
Wealth: $57,619
www.StudsPlanet.com

75. Consumption vs. Wealth
10
57.6
0
50
0
10
20
30
40
50
60
70
0 10 20 30 40 50 60 70
www.StudsPlanet.com

76. Consumption and Wealth
• With capital markets, consumption is not
determined by current income, but by wealth
(present value of lifetime income)
www.StudsPlanet.com

77. Consumption and Wealth
• With capital markets, consumption is not
determined by current income, but by wealth
(present value of lifetime income)
• These two individuals, having the same wealth,
should choose the same consumption
www.StudsPlanet.com

78. Consumption vs. Wealth
10
57.6
0
50
0
10
20
30
40
50
60
70
0 10 20 30 40 50 60 70
www.StudsPlanet.com

79. Again, assume that the interest rate is 5%, consider
two individuals
• Person A
• Current income: $10,000
• Anticipated future
income: $50,000
Wealth: $57,619
Current Spending:
$30,000
Person B
• Current Income: $50,000
• Anticipated Future
income: $8,000
Wealth: $57,619
Current Spending:
$30,000
www.StudsPlanet.com

80. Again, assume that the interest rate is 5%, consider
two individuals
• Person A
• Current income: $10,000
• Anticipated future
income: $50,000
Wealth: $57,619
Current Spending:
$30,000
Savings: -$20,000
Person B
• Current Income: $50,000
• Anticipated Future
income: $8,000
Wealth: $57,619
Current Spending:
$30,000
Savings: $20,000
www.StudsPlanet.com

81. Again, assume that the interest rate is 5%, consider
two individuals
• Person A
• Current income: $10,000
• Anticipated future
income: $50,000
Wealth: $57,619
Current Spending:
$30,000
Savings: -$20,000
Future Spending: $29,000
Person B
• Current Income: $50,000
• Anticipated Future
income: $8,000
Wealth: $57,619
Current Spending:
$30,000
Savings: $20,000
Future Spending: $29,000
www.StudsPlanet.com

82. Consumption and Wealth
• With capital markets, consumption is not
determined by current income, but by wealth
(present value of lifetime income)
• These two individuals, having the same wealth,
should choose the same consumption.
• For a given level of wealth, those with high rates
of income growth would be expected to be
borrowers
www.StudsPlanet.com

83. Suppose that economic growth in the US rises. What
should happen to aggregate savings?
0
1
2
3
4
5
6
7
8
9
0 10 20 30 40 50
Savings ($)
InterestRate(%)
www.StudsPlanet.com

84. Suppose that economic growth in the US rises. What
should happen to aggregate savings?
0
2
4
6
8
10
12
0 10 20 30 40 50
Savings ($)
InterestRate(%)
www.StudsPlanet.com

85. Technology & Investment
Demand
• Recall that an economy has three sources of
growth: labor, capital, and technology
www.StudsPlanet.com

86. Production Technology
• Recall that an economy has three sources of
growth: labor, capital, and technology
• The production function describes the
relationship between output and the three
www.StudsPlanet.com

87. Production (Holding Employment Fixed)
www.StudsPlanet.com

88. Production (Holding Employment Fixed)
0
10
20
30
40
50
60
70
80
90
0 2 4 6 8 10
Capital
Output
www.StudsPlanet.com

89. Marginal Product of Capital
• The marginal product of capital is defined as
the additional output produced by each
additional unit of capital purchased.
• In the previous slide, the first unit of capital
generated 25 units of output while the second
unit of capital raised total output from 20 to 45
• Therefore, the MPK of the first unit of capital
is 25 while the MPK of the second unit of
capital is 20
www.StudsPlanet.com

90. Diminishing marginal product implies that as the
capital stock rises, the marginal product of
additional capital falls
0
10
20
30
40
50
60
70
80
90
0 2 4 6 8 10
Capital
Output
0
5
10
15
20
25
30
www.StudsPlanet.com

91. Marginal Product and Investment Demand
• Recall that investment refers to the purchase
of new capital equipment by the private
sector
www.StudsPlanet.com

92. Marginal Product and Investment Demand
• Recall that investment refers to the purchase
of new capital equipment by the private
sector
• Firms are profit maximizers and, hence,
only take actions that increase firm value
(present value of lifetime earnings)
www.StudsPlanet.com

93. Marginal Product and Investment Demand
• Recall that investment refers to the purchase of
new capital equipment by the private sector
• Firms are profit maximizers and, hence, only take
actions that increase firm value (present value of
lifetime earnings)
• Therefore a firm will only buy a new piece of
capital when the contribution of that capital to
firm value is greater that its cost
P(k) > PV(MPK)
www.StudsPlanet.com

94. A Numerical example
• Suppose that the current interest rate is 5% and that the
cost of a unit of machinery is $100. Capital is assumed to
depreciate at a rate of 10% per year.
www.StudsPlanet.com

95. A Numerical example
• Suppose that the current interest rate is 5% and that the
cost of a unit of machinery is $100.
• Given the technology from the previous slide, the marginal
product of the first unit of capital is $25/yr. Income stream
will this capital generate?
• Year 1: $25
Year 2: $25(1-.10) = $22.50
Year 3: $25(1-.10)(1-.10) = $20.25
Year 3: $25(1-.10)(1-.10)(1-.10) = $18.23 …………
www.StudsPlanet.com

96. A Numerical example
• What is the present value of this income stream?
www.StudsPlanet.com

97. A Numerical example
• What is the present value of this income stream?
PV = $25/(1.05) + $22.50/(1.05)^2 + $20.25/(1.05)^3 + …….
www.StudsPlanet.com

98. A Numerical example
• What is the present value of this income stream?
PV = $25/(1.05) + $22.50/(1.05)^2 + $20.25/(1.05)^3 + …….
PV = $25/( i + depreciation ) = $25/(.15) = $167
• Is this a positive NPV project? Yes ( $167 > $100)
www.StudsPlanet.com

99. A Numerical example
• What is the present value of this income stream?
PV = $25/(1.05) + $22.50/(1.05)^2 + $20.25/(1.05)^3 + …….
PV = $25/( i + depreciation ) = $25/(.15) = $167
• Is this a positive NPV project? Yes ( $167 > $100)
• In fact, solving the above expression tells us that this is a positive
NPV project for any interest rate under
i = (MPK/Pk) – depreciation = ($25/$100) - .10 = .15 = 15%
www.StudsPlanet.com

100. Interest rates and Investment
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7
www.StudsPlanet.com

101. Interest rates and investment
• Note that once the first unit of capital has
been purchased, the second unit of capital
only has a marginal product of 20.
• Therefore, for this unit of capital to be a
positive PV project, the interest rate must
be lower than 20/100 - .10 = .1 = 10%
www.StudsPlanet.com

102. Interest rates and Investment
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7
www.StudsPlanet.com

103. Interest rates and Investment
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5
www.StudsPlanet.com

104. Interest rates and investment
• Diminishing marginal product of Capital
guarantees that the demand for investment
is downward sloping (increasing rates of
investment require lower interest rates)
• To get the total demand for loans, multiply
the investment curve by the price of capital)
www.StudsPlanet.com

105. Interest rates and Investment
0
2
4
6
8
10
12
14
16
0 100 200 300 400 500
www.StudsPlanet.com

106. Investment Demand
• It is assumed that labor and capital are
compliments. That is, when employment
rises, the productivity of capital increases as
well.
www.StudsPlanet.com

107. Investment Demand
• It is assumed that labor and capital are
compliments. That is, when employment
rises, the productivity of capital increases as
well.
• Therefore, as a rise in employment should
increase the demand for capital and, hence,
the demand for loans
www.StudsPlanet.com

108. Investment Demand
• It is assumed that labor and capital are
compliments. That is, when employment rises, the
productivity of capital increases as well.
• Therefore, as a rise in employment should increase
the demand for capital and, hence, the demand for
loans
• Further, any technological improvement should
also raise the demand for investment
www.StudsPlanet.com

109. A rise in investment demand
0
2
4
6
8
10
12
14
16
0 100 200 300 400 500
www.StudsPlanet.com

110. A rise in investment demand
0
5
10
15
20
25
0 100 200 300 400 500
www.StudsPlanet.com

111. Capital Market Equilibrium
• For now, assume that there is
no government and the US is a
closed economy
• Add up individual firm’s hiring
decisions to get aggregate
investment
• Add up individual household
decisions to get aggregate
savings
• A capital market equilibrium is
an interest rate that clears the
market (i.e.,savings equals
investment)
• Here, i*= 10%, S* = I*= 300
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

112. Example: Post-war Germany
• It is estimated that 20-25% of
Germany’s capital stock was
destroyed during WWII. How
would the German capital
market respond to this?
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

113. Example: Post-war Germany
• It is estimated that 20-25% of
Germany’s capital stock was
destroyed during WWII. How
would the German capital
market respond to this?
• A lower capital stock decreases
increases the productivity of
new investment and, thus
increases investment demand
0
4
8
12
16
20
24
0 100 200 300 400 500
www.StudsPlanet.com

114. Example: Post-war Germany
• It is estimated that 20-25% of
Germany’s capital stock was
destroyed during WWII. How
would the German capital
market respond to this?
• A lower capital stock decreases
increases the productivity of
new investment and, thus
increases investment demand
• The resulting higher
equilibrium has a higher
interest rate, higher savings and
investment
0
4
8
12
16
20
24
0 100 200 300 400 500
www.StudsPlanet.com

115. Example:The Bubonic Plague
• The Bubonic Plague, or “Black
Death” ravaged Europe in the
1300’s. From 1347-1352,
approximately 30% of the
population in Europe was killed
(25 million). What impact will
this have on capital markets?
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

116. Example:The Bubonic Plague
• The Bubonic Plague, or “Black
Death” ravaged Europe in the
1300’s. From 1347-1352,
approximately 30% of the
population in Europe was killed
(25 million). What impact will
this have on capital markets?
• A decrease in employment
lowers the productivity of
investment (labor and capital
are complements) and, hence,
investment demand
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

117. Example:The Bubonic Plague
• The Bubonic Plague, or “Black
Death” ravaged Europe in the
1300’s. From 1347-1352,
approximately 30% of the
population in Europe was killed
(25 million). What impact will
this have on capital markets?
• A decrease in employment
lowers the productivity of
investment (labor and capital
are complements) and, hence,
investment demand
• The result: lower interest rates,
savings, and investment
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

118. Temporary vs. Permanent Shocks
• Unlike labor markets, the
timing and persistence of
productivity shock are
important
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

119. Temporary vs. Permanent Shocks
• Unlike labor markets, the
timing and persistence of
productivity shock are
important
• New capital takes time to
install. Therefore, productivity
improvements must be long
lasting to effect investment
demand
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

120. Temporary vs. Permanent Shocks
• Unlike labor markets, the
timing and persistence of
productivity shock are
important
• New capital takes time to
install. Therefore, productivity
improvements must be long
lasting to effect investment
demand
• A temporary improvement in
productivity will increase
savings (as consumers smooth
this extra income), but have no
impact on investment
0
4
8
12
16
20
0 100 200 300 400 500
www.StudsPlanet.com

121. Temporary vs. Permanent Shocks
• Unlike labor markets, the
timing and persistence of
productivity shock are
important
• New capital takes time to
install. Therefore, productivity
improvements must be long
lasting to effect investment
demand
• On the other hand, a permanent
technological improvement will
increase investment, but have
little impact on savings
0
4
8
12
16
20
24
0 100 200 300 400 500
www.StudsPlanet.com