Download Chapter 9 Saving, Investment, and Interest Rates

Chapter 9
Saving, Investment, and Interest Rates
After reading Chapter 9, SAVING, INVESTMENT, AND INTEREST RATES, you should be able to:
• Discuss the Consumption Function and the Saving Function and explain how consumption and
saving are related to income and the interest rate.
• Discuss the Life-Cycle Theory of Consumption.
•
•
•
•
Differentiate between the Nominal Rate of Interest and the Real Rate of Interest.
Explain how interest rates and saving and interest rates and Investment are related.
Define Credit Markets and explain how the Market Rate of Interest is determined.
Discuss the Structure of Interest Rates, and explain how interest rates vary with Risk, Liquidity, and
Maturity.
T Outline
I.
Consumption and Savings
A) Household Savings (or personal savings) is what we have left over from our income after
buying goods and services and paying our income taxes.
B) We can save only by reducing consumption. When we save, we add to our assets by increasing
funds in savings accounts, by purchasing bonds, stocks, etc.
C) How much of our income we consume depends on the income we earn after taxes and the
interest rate.
D) The Consumption Function shows how much a household wishes to consume at each level of
income and interest rate: C = f (Y, r). Consumption increases with income and decreases with
the interest rate.
E) The Saving Function shows how much a household wishes to save at each level of income and
interest rate: S = F (Y, r). Saving increases with income and increases with the interest rate.
II.
Life-Cycle Consumption
A) According to the Life-Cycle Theory of Consumption, households base their consumption and
saving decisions on the long-term income they expect to earn over their lifetimes.
B) Typical households start with low income and consume more than their income when they are
“young”; mature households have higher incomes and accumulate savings for their old age; old
households live off their savings.
C) Through buying on credit or saving, households are able to smooth out fluctuations in their
consumption over their lifetime.
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III. Real Verus Nominal Interest Rates
A) There are two types of interest rates:
1. The Nominal Interest Rate is the contractual interest rate that is earned in credit markets.
2. The Real Interest Rate is the nominal rate of interest over some period minus the expected
rate of inflation over the same period.
B) Real interest rate is forward-looking: Lenders make their decisions based on the current nominal
rate minus the expected inflation rate over the period of the loan. Actual inflation can be
different; we can observe the actual real interest rate earned by the savers after the end of the
period by deducting the actual inflation rate from the nominal rate.
C) Changes in the real interest rate affect the terms on which we can exchange current and future
consumption. A higher interest rate implies cheaper future consumption and encourages people
to save more. The relationship between the real interest rate and the amount of saving is
positive.
IV. Interest Rates and Savings
A) Consumption today is preferable over consumption tomorrow: by consuming our income today,
we get instant satisfaction.
B) The Interest Rate constitutes the reward for postponing consumption into the future.
C) Interest rates determine saving decisions: an increase in the rate of interest, holding other factors
constant, encourages us to save more (to postpone more consumption).
V.
Interest Rates and Investment
A) The term Investment refers to business investment in new plants, equipment, and inventories.
B) The key determinants of investment are
1. the expectations of the future profits.
2. the costs of borrowing.
C) Businesses compare the rate of return of an investment to the cost of acquiring additional
capital.
Firms carry out additional investments as long as their rate of return exceeds the market rate of
interest. The last investment project should yield a rate of return equal to the market interest
rate.
D) The firm’s Investment Demand Curve shows the amount of investment desired at different
interest rates, and the investment demand curve is negatively sloped: the amount of desired
investment increases as the interest rate falls. The investment demand curve of the economy
shows the amount of investment desired at different interest rates by the economy as a whole.
VI. Credit Markets and Interest Rates
A) A large portion of the economy’s investment is financed directly by savings of the business
firms. Those projects that cannot be paid for out of the firm’s own saving must be financed by
the saving of others. Credit Markets are markets in which borrowers come together with
lenders to determine conditions of exchange such as interest rates and the duration of the loan.
B) The Market (or Equilibrium) Rate of Interest is the rate of interest that equates the quantity of
investment and the quantity of saving. It is determined by the supply of savings and the demand
for savings (the demand for investment).
Chapter 9
Saving, Investment, and Interest Rates
95
C) At an interest rate above the equilibrium rate, savers will want to lend more than investing firms
wish to borrow. Eventually, the interest rate will drop. At an interest rate below the equilibrium
rate, firms will want to borrow more than savers wish to save. Eventually, the interest rate will
rise.
D) If households becomes more thrifty, they will save more at each rate of interest. With an
increase in the supply of savings, the interest rate should fall and the volume of investment will
become greater.
VII. The Structure of the Interest Rates
A) There are many types of borrowers in credit markets: businesses who wish to launch new
projects, households who wish to finance home purchase or new cars, governments whose
budgets are in deficit. The interest rate is not the same for all borrowers, and different interest
rates are paid on different financial assets.
B) Interest rates vary with the conditions of Risk, Liquidity, and Maturity associated with a loan.
1. Lenders must be compensated for the extra risk of lending to borrowers with poor credit
ratings. The greater the risk associated with the loan, the higher the interest rate. The risk
premium is the additional interest paid by high risk borrowers.
2. Financial assets are called liquid if they can be turned into cash quickly or with a small
penalty. Interest rates vary inversely with liquidity.
3. Interest rates vary with the term of maturity, that is, the length of the borrowing period.
VIII. Investment Cyles and Bubbles
A) Changes in the prices of a stock or prices of the stock market in general act as a signal of
changes in investor expectations.
B) In the mid 1990’s a stock bubble formed due to a surge in optimism about future profits in the
‘new economy’. By 1999 the bubble burst are investor’s irrational exuberance collapsed.
C) An Investment Cycle occurs when businesses make poor investment decisions and drive actual
rates of return below the interest rate.
T Review Questions
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question
give a short statement that supports your answer.
_____
1.
The consumption function is the same as the saving function since both are determined by a
household income and interest rate.
_____
2.
Given a constant rate of interest, both consumption and saving increase as the income
increases.
_____
3.
Given an unchanging level of income, consumption falls and saving rises as the rate of
interest increases.
_____
4.
The life-cycle theory of consumption states that people base their consumption and saving
decisions on their current level of income.
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Gregory • Essentials of Economics, Sixth Edition
_____
5.
The nominal rate of interest is crucial in making saving decisions since it adjusts for
inflation.
_____
6.
The real interest rate equals the nominal rate of interest when there is no inflation.
_____
7.
The greater the real interest rate, the more people are encouraged to save.
_____
8.
Credit markets serve the function of equating personal income and personal savings.
_____
9.
Business firms will fund investment projects so long as these projects provide a positive rate
of return.
_____
10. Demand for investment by the entire economy increases as the business expectations become
more optimistic.
Multiple Choice Questions
Circle the letter corresponding to the correct answer.
1.
Suppose a $20 million investment project promises to add $1 million to profits each year for an
almost infinite period. What is the rate of return on this investment project?
(a) 5 percent
(b) 10 percent
(c) 19 percent
(d) 20 percent
(e) 21 percent
2.
In any given period, a firm chooses to carry out an additional investment project according to the
following information:
(a) the cost of its projects.
(b) the state of the firm’s own savings.
(c) the market rate of interest.
(d) the rate of return on investment.
(e) (c) and (d).
3.
The market interest rate is the rate of interest that equates
(a) the real rate of interest with the rate of return on an investment project.
(b) the quantity of investment with the quantity of saving.
(c) the amount of savings with consumption expenditures.
(d) the real rate of interest with the nominal interest rate.
(e) present and future consumption.
Chapter 9
Saving, Investment, and Interest Rates
97
4.
In the situation when lenders cannot find enough borrowers, the interest rate
(a) increases.
(b) drops.
(c) remains the same until the businesses find profitable projects, and then increases.
(d) remains the same until the businesses find profitable projects, and then drops.
(e) all of the above is possible.
5.
Which of the following is correct? Savings can be made by
(a) government.
(b) households.
(c) businesses.
(d) (b) and (c).
(e) all of the above.
6.
People are able to smooth out fluctuations in their consumption because they can
(a) borrow over entire lifetimes.
(b) save over entire lifetimes.
(c) borrow when they expect their income to rise and save when they expect their income to decline.
(d) borrow and/or save depending on the real rate of interest.
(e) borrow and/or save depending on the nominal rate of interest.
7.
The real interest rate formula includes
(a) the nominal rate of interest and the actual rate of inflation.
(b) the nominal rate of interest and the anticipated rate of inflation.
(c) the market interest rate and the expected demand for investment.
(d) the nominal rate of interest and market prices.
(e) all of the above.
8.
Under which of the following conditions will the interest rate on a loan tend to be the highest?
(a) High risk, high liquidity, short term of maturity
(b) High risk, low liquidity, long term of maturity
(c) Low risk, high liquidity, long term of maturity
(d) Low risk, low liquidity, long term of maturity
(e) Both a and d
Essay Questions
Write a short essay or otherwise answer each question.
1.
Draw a diagram showing life-cycle consumption and income, and explain it. What would the
diagram’s consumption curve look like if people were basing their consumption and saving decisions
on current earnings?
2.
What is the investment demand curve of the economy? Why is it downward sloping?
3.
Explain how the economy equates investment and saving. How will market equilibrium be affected
by a momentary increase in the interest rate? Draw an appropriate diagram.
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Gregory • Essentials of Economics, Sixth Edition
4.
Explain why an increase in the thrift of households yields a lower interest rate and a greater volume
of investment. Draw an appropriate diagram.
5.
A firm is considering three investment projects. Costs of the projects are $5 million, $10 million, and
$20 million, respectively. Each project promises to bring profits of $1 million per year for a very long
period. Which of the projects will the firm decide to carry out, if the market interest rate is 9.9%?
Assume that there is no inflation and that the firm can finance the projects only by borrowing in the
credit market.
6.
In the problem above, assume that the firm is known to have had problems with repaying debts in the
past. How may this affect the firm’s investment decisions? Use the concept of “risk premium” in your
answer.
T Answers to Review Questions
True/False
1.
False. Although both functions have similar form, their meanings are different: the consumption
function shows how much a household wishes to consume at each level of income and interest rate,
and the saving function deals with that portion of income that is left over after consumption.
2.
True. If the interest rate holds constant, a household will normally spend and save more as its income
increases.
3.
True. The interest rate is the reward for saving. When our income does not change, we usually choose
to save more and spend less as the interest rate increases.
4.
False. The life-cycle theory of consumption predicts that people tend to smooth out fluctuations in
consumption over time by anticipating future changes in their incomes. Young people borrow,
expecting future rises in their incomes, while mature people consume less and save more, expecting
their income to shrink as they become old.
5.
False. It is the real interest rate that anticipates inflation and affects saving decisions.
6.
True. The real interest rate is defined as the nominal rate of interest minus anticipated inflation.
7.
True. Changes in the real interest rate affect the terms on which we can exchange current and future
consumption. Thus, a higher interest rate translates into cheaper future consumption.
8.
False. Credit markets bring together businesses that wish to invest with savers who supply their
savings.
9.
False. Business firms will fund investment projects until the rate of return on the last project is equal
to the market interest rate.
10. False. Demand for investment by the entire economy increases as the interest rate declines.
Chapter 9
Saving, Investment, and Interest Rates
99
Multiple Choice Questions
1.
(a) The rate of return on a $20 million investment project is 5 percent—the annual addition to profit
divided by the cost of the project.
2.
(e) Firms carry out additional investment projects as long as their rate of return exceeds the market
rate of interest.
3.
(b) The credit market is in equilibrium at an interest rate that equates the desired amount of
investment with the desired amount of saving.
4.
(b) If the amount of desired investment exceeds the amount of desired saving, and lenders cannot
find enough borrowers, the interest rate drops until the credit market reaches an equilibrium.
5.
(e) Not all saving in the economy is the personal saving. Businesses save by retaining profits that are
not distributed to owners as dividends and by setting aside funds to replace capital that is
depreciating. Also the government saves by spending less than it collects in taxes.
6.
(c) According to the life-cycle theory of consumption, in order to avoid swings in consumption,
people borrow when they are young, expecting that their incomes will eventually rise; and
people save as they become mature, expecting that their incomes will fall when they are old.
7.
(b) The real interest rate is the nominal rate minus anticipated inflation. This formula does not claim
that we correctly anticipate inflation. Actual inflation can be different from expected. After the
fact, however, we can look back and observe the actual interest rate earned by savers by
deducting the actual inflation rate from the nominal rate.
8.
(b) Interest rates vary with the conditions of risk, liquidity, and maturity associated with a loan.
Higher risk, lower liquidity, and longer term of maturity make the loans less profitable for the
lenders. To compensate, lenders will charge higher interest rates on loans if one or more of these
conditions are met.
Essay Questions
1.
See Figure 9.2 in the textbook.
People base their consumption and saving decisions on the long-term income they expect to earn over
their lifetimes. For this reason, the consumption curve is smoother than the income curve. Young
households start with low income; in the anticipation of growing income in the future, they borrow
and consume more than they earn. Mature households have higher incomes and save for their old age;
their consumption is less than their current income. Old households live off their savings, consuming
again in excess of their income. If people were basing their consumption and saving decisions on
current earnings only, the consumption curve would run close to the income curve: there would be no
reason for the households to borrow or save much, if they did not anticipate significant changes in
their future income.
2.
The investment demand curve of the economy shows the amount of investment desired at different
interest rates by the economy as a whole. A downward slope of the curve means that the firms in the
economy are willing to undertake a greater number of new investments as the interest rate falls, and
vice versa. This happens because the interest rate is the cost of acquiring capital for the firms. The
lower these costs, the greater number of investment projects that become profitable, and the more
firms are willing to make new investments.
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Gregory • Essentials of Economics, Sixth Edition
3.
The saving function shows how much a household wishes to save at each level of income and interest
rate. The investment demand curve shows the amount of investment desired at different interest rates.
The saving function is positively sloped: a higher interest rate brings forth more saving. The
investment demand curve is negatively sloped: a lower interest rate encourages investment. At the
point where the saving and investment demand functions intersect the quantity of investment is equal
to the quantity of saving. The vertical coordinate of this point is the equilibrium rate of interest. A
momentary increase in the interest rate will result in a disequilibrium in the credit market: the desired
amount of saving exceeds the desired amount of investment; some lenders are unable to find
borrowers for their savings.
See Figure 9.5 in the textbook.
4.
The increase in household thrift causes the saving function to shift to the right: households are willing
to save more under the same interest rate. The point where the saving function and the investment
demand curve intersect will move downward and to the right, which means a lower interest rate and a
greater volume of investment in the new equilibrium.
See Figure 9.6 in the textbook.
5.
The firm will carry out those projects that promise returns exceeding the costs of acquiring the
capital, or, in other words, when the rate of return exceeds the market interest rate. The projects’ rates
of return are: 20% (=1/5), 10% (=1/10), and 5% (=1/20), respectively. The first two numbers exceed
the market interest rate, while the last one falls short of it. Hence, the firm should reject the third
project.
6.
If the firm had problems with repaying debts in the past, it can be expected to fail to repay a loan
again. This firm has a poor credit rating; that is, lending to it is risky. Lenders must be compensated for
the risk of lending to borrowers with poor credit rating. This compensation comes in the form of a
higher interest rate, paid by low-rated borrowers. This extra interest is called risk premium. It is quite
likely that the firm in this problem will have to pay an interest rate exceeding 10% (market interest
rate of 9.9% plus some risk premium). Then, only the first project, yielding a 20% rate of return, will
be profitable.
T Additional Questions
1.
Consider the following simple example about the life-cycle theory of consumption. You start work
this year and work for five years and then you retire. In the first year you make $20,000 per year. In
each of the following four years your salary increases by 10% per year. After you retire you live for
two more years, and then sadly, you die. Assume that you earn no interest on savings and pay no
interest on borrowing. How much will you consume in each year? In what years do you borrow? In
what years do you save?
2.
Suppose the nominal rate of interest is 8% and the expected rate of inflation is 4%. What is the real
interest rate? Holding the real rate of interest fixed, what would happen to the nominal rate of interest
if the expected rate of inflation increased to 7%.
3.
On a credit market diagram show what happens to the interest rate and the amount of investment
undertaken if households decide to spend a greater percentage of their income.
Chapter 9
4.
Saving, Investment, and Interest Rates
101
Consider the discussion in your textbook on the structure of interest rates, and answer the following
questions.
(a) Why would the annual interest rate on a US government bond that matures in 5 years be 4.35%
while the annual interest rate on a US government bond that matures in 30 years by 6.5%.
(b) What effect do you think the effect of tobacco company lawsuits has had on the interest rate paid
on bonds offered by cigarette companies.
(c) Why would the interest rate on a bond issued by Ford Motor company that matures in five years
have a lower interest rate than a bond issued by Hydrogenics, a small company that manufactures
fuel cells, that matures at the same time.
Answers
1.
Your total income for the first five years is $122,102 ($20,000 + $22,000 + $24,200 + $26,620 +
$29,282). Over the course of your seven year life span this will allow you to have annual
consumption of $17,443.14 ($122,102/7). In this case you never borrow, save in each of the five
working years, which you live off in your last two years.
2.
The real rate of interest is the nominal rate of interest minus the expected rate of inflation. Therefore,
the real rate of interest is 8% – 4% = 4%. If the expected rate of inflation increased to 7%, the
nominal rate of interest would need to increase to 11% to maintain the same real rate (nominal =
real + expected inflation).
3.
If households spend a greater percentage of their income then they must be saving a smaller
percentage of their income. Therefore, the supply of savings will decrease—shift to the left. This
causes the interest rate to rise from i0 to i1 and the amount of investment to fall from I0 to I1.
4.
(a) The difference in interest rates are due to maturity risk. As the term to maturity increases, so does
the interest rate.
(b) The tobacco lawsuits caused the interest rates to rise since the risk of default on the bonds has
increased. The risk premium has increased.
(c) Two factors could come into play here. First, Ford Motor company may have less risk associated
with it so its bonds would have a lower interest rate than Hydrogenics. Second, there may also be
some liquidity risk associated with Hydrogenics bonds since it is a less well known company and
there may not be a large market for them.