Capital markets

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Capital markets

  1. 1. Capital Markets Savings, Investment, and Interest Rates www.StudsPlanet.com
  2. 2. Some Useful Terminology • Savings: Current income which is deferred for future consumption (i.e., not spent) www.StudsPlanet.com
  3. 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. 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. 5. Some Useful Terminology • Investment: The purchase of new capital goods. www.StudsPlanet.com
  6. 6. Some Useful Terminology • Investment: The purchase of new capital goods. – Gross Investment: Total purchases of new capital goods www.StudsPlanet.com
  7. 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. 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. 9. NIPA Accounts • Recall, the accounting identity in the NIPA accounts: GDP = C + I + G + NX www.StudsPlanet.com
  10. 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. 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. 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. 13. Interest Rates • What is an interest rate? www.StudsPlanet.com
  14. 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. 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. 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. 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. 18. The Yield Curve www.StudsPlanet.com
  19. 19. Yield Curves • What determines the shape of the yield curve? – Segmented Markets Hypothesis – Expectations Hypothesis – Preferred Habitat Hypothesis www.StudsPlanet.com
  20. 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. 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. 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. 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. 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. 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. 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. 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. 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. 29. Present Value • With a positive interest rate, income received in the future is less valuable that income received immediately. www.StudsPlanet.com
  30. 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. 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. 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. 33. Income vs. Wealth • Your wealth is defined and the present value of your lifetime income. www.StudsPlanet.com
  34. 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. 35. Household Savings • Without an active capital markets, household consumption is restricted to equal current income (that is, C=Y) www.StudsPlanet.com
  36. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 58. Consumption Possibilities Current Consumption (000s) FutuerConsumption(000s) www.StudsPlanet.com
  59. 59. Consumption Possibilities Current Consumption (000s) FutureConsumption(000s) www.StudsPlanet.com
  60. 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. 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. 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. 63. How does rising interest rates influence savings decisions? www.StudsPlanet.com
  64. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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: $29,000 www.StudsPlanet.com
  82. 82. Consumption and Wealth • With capital markets, consumption is not determined by current income, but by wealth (present value of lifetime income) • These two individuals, having the same wealth, should choose the same consumption. • For a given level of wealth, those with high rates of income growth would be expected to be borrowers www.StudsPlanet.com
  83. 83. Suppose that economic growth in the US rises. What should happen to aggregate savings? 0 1 2 3 4 5 6 7 8 9 0 10 20 30 40 50 Savings ($) InterestRate(%) www.StudsPlanet.com
  84. 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. 85. Technology & Investment Demand • Recall that an economy has three sources of growth: labor, capital, and technology www.StudsPlanet.com
  86. 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. 87. Production (Holding Employment Fixed) www.StudsPlanet.com
  88. 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. 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. 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. 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. 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. 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. 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. 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. 96. A Numerical example • What is the present value of this income stream? www.StudsPlanet.com
  97. 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. 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. 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. 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. 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. 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. 103. Interest rates and Investment 0 2 4 6 8 10 12 14 16 0 1 2 3 4 5 www.StudsPlanet.com
  104. 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. 105. Interest rates and Investment 0 2 4 6 8 10 12 14 16 0 100 200 300 400 500 www.StudsPlanet.com
  106. 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. 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. 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. 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. 110. A rise in investment demand 0 5 10 15 20 25 0 100 200 300 400 500 www.StudsPlanet.com
  111. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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

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