Download Investment and Financial Markets

Economics
NINTH EDITION
Chapter 12
Investment and
Financial Markets
Prepared by Brock Williams
Copyright © 2017, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Learning Objectives
12.1 Explain why investment spending is a volatile
component of GDP.
12.2 Discuss the concept of present value.
12.3 Describe the role of interest rates in making investment
decisions.
12.4 List the ways that financial intermediation can facilitate
investment.
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12.1 AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN (1 of 2)
• Accelerator theory
The theory of investment that says
that current investment spending
depends positively on the expected
future growth of real GDP.
The share of investment as a
component of GDP ranged from a
low of about 10 percent in 1975 to a
high of over 18 percent in 2000.
The shaded areas represent U.S.
recessions.
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12.1 AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN (2 of 2)
• Procyclical
Moving in the same direction as real GDP.
• Multiplier-accelerator model
A model in which a downturn in real GDP leads to a sharp fall in
investment, which triggers further reductions in GDP through the
multiplier.
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APPLICATION 1
ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING
APPLYING THE CONCEPTS #1: How do fluctuations in energy prices affect
investment decisions by firms?
One important way volatility of oil prices can hurt the economy is by creating uncertainty for
firms making investment decisions.
Consider whether a firm should invest in an energy-saving technology for a new plant:
• If energy prices remain high, it may be profitable to invest in energy-saving technology.
• If prices fall, these investments would be unwise.
• If future oil prices are uncertain, a firm may simply delay building the plant until the path of oil
prices are clear.
When firms are faced with an increasingly uncertain future, they will delay their investment
decisions until the uncertainty is resolved.
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12.2 EVALUATING THE FUTURE (1 of 3)
Understanding Present Value
PRESENT VALUE AND INTEREST RATES
• Present value
The maximum amount a person is willing to pay today to receive a payment in the future.
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
1.
The present value—the value today—of a given payment in the future is the maximum amount a
person is willing to pay today for that payment.
2.
As the interest rate increases, the opportunity cost of your funds also increases, so the present
value of a given payment in the future falls. In other words, you need less money today to get to your
future “money goal.”
3.
As the interest rate decreases, the opportunity cost of your funds also decreases, so the present
value of a given payment in the future rises. In other words, you need more money today to get to
your money goal.
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APPLICATION 2
THE VALUE OF AN ANNUITY
APPLYING THE CONCEPTS #2: How can understanding the concept of present value
help us evaluate an annuity?
• Suppose you and your employer both had set aside funds for the day you retire at age 65. Just before
you retire, your employer offers you’re the following options: 1) You can have the $500,000 that was
set aside, or 2) the firm would take the $500,000 and purchase you an annuity contract---a financial
instrument that would pay you a fixed annual payment of $35,000 per year as long as you live.
• The first step in making this decision would be to calculate the present value of the annuity payments
and compare it to the $500,000. Of course,, you do not know for sure how long you would live, so you
would need some estimates of the probability of surviving at each age into the future. You would
multiply that probability by the yearly annuity payment to obtain an expected annuity payment for
every future year. Finally, you could need to choose an interest rate and calculate the expected
present value of the annuity payments and compare it to the $500,000.
• Hopefully, your firm offered you a well-price annuity. But the decision is still yours. The annuity would
be a better deal for you if you were healthier than average and expected to live longer than the
average person. On the other hand, if you had poor health, it would not be a good idea.
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12.2 EVALUATING THE FUTURE (2 of 3)
Real and Nominal Interest Rates
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—the purchasing
power—not the face value of money.
• Nominal interest rate
Interest rates quoted in the market.
• Real interest rate
The nominal interest rate minus the interest rate
• Expected real interest rate
•
•
The nominal interest rate minus the expected inflation rate.
real rate = nominal rate – inflation rate
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12.2 EVALUATING THE FUTURE (3 of 3)
• There are different types of interest
investments.
• Corporate bonds are considered
more risky than federal government
bonds, so pay a higher interest rate.
• Long term investments are more
risky than short term investments,
so again pay a higher interest rate.
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12.3 UNDERSTANDING INVESTMENT
DECISIONS (1 of 3)
As the real interest rate declines,
investment spending in the
economy increases.
• Neoclassical theory of
investment
A theory of investment that says both
real interest rates and taxes are
important determinants of investment.
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12.3 UNDERSTANDING INVESTMENT
DECISIONS (2 of 3)
Investment and the Stock Market
• Retained earnings
Corporate earnings that are not paid out as dividends to their owners.
• Corporate bond
A bond sold by a corporation to the public in order to borrow money.
• Q-theory of investment
The theory of investment that links investment spending to stock prices.
price of a stock = present value of expected future dividend payments
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12.3 UNDERSTANDING INVESTMENT
DECISIONS (3 of 3)
Both the stock market and
investment spending rose sharply
from 1997, peaking in mid-2000.
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12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (1 of 4)
• Liquid
Easily convertible into money on
short notice.
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12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (2 of 4)
• Financial intermediaries
Organizations that receive funds
from savers and channel them to
investors.
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12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (3 of 4)
• Securitization
•
The practice of purchasing loans, re-packaging them, and selling them to the financial
markets.
• Leverage
•
Using borrowed funds to purchase assets.
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APPLICATION 3
UNDERWATER HOMEOWNERS AND DEBT FORGIVENESS?
APPLYING THE CONCEPTS #3: Should we have done more to assist homeowners
with burdensome mortgage debt?
•
•
•
•
During the housing boom, many homeowners borrowed money to purchase their property but then saw
the value of their homes fall sharply. In 2012 approximately 12 million U.S. homeowners owed more on
their home mortgages than their home was actually worth, this is commonly known as being
“underwater.” Should we have tried to help them more?
Atif Mian and Amir Sufi provided strong evidence that in the aftermath of the Great Recession, the
speed of recovery depended critically on providing assistance to underwater homeowners.
Households with higher debt burdens reduced spending more than those with lower debt burdens by a
factor of almost three to one. By not helping those homeowners, consumption spending was
substantially reduced.
Policymakers tried a variety of programs but they proved to be controversial and difficult to administer.
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12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT (4 of 4)
When Financial Intermediaries Malfunction
• Bank run
Panicky investors simultaneously trying to withdraw their funds from a bank they believe
may fail.
• Deposit insurance
Federal government insurance on deposits in banks and savings and loans.
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APPLICATION 4
SECURITIZATION: THE GOOD, THE BAD, AND THE UGLY
APPLYING THE CONCEPTS #4: How have recent financial innovations created new
risks for the economy?
• As securitization developed, it allowed financial intermediaries to provide new funds for
borrowers to enter the housing market.
• As the housing boom began in 2002, lenders and home purchasers began to take increasing
risks. Lenders made “subprime” loans to borrowers with limited ability to actually repay their
mortgages.
• Some households were willing to take on considerable debt because they were confident they
could make money in a rising housing market. Lenders securitized the subprime loans and
financial firms offered exotic investment securities to investors based on these loans. Many
financial institutions purchased these securities without really knowing what was inside them.
• When the housing boom stopped and borrowers stopped making payments on subprime
loans, it created panic in the financial market. Effectively, through securitization the damage
from the subprime loans spread to the entire financial market, causing a major crisis.
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KEY TERMS
Accelerator theory
Neoclassical theory of investment
Bank run
Nominal interest rate
Corporate bond
Present value
Deposit insurance
Procyclical
Expected real interest rate
Q-theory of investment
Financial intermediaries
Real interest rate
Leverage
Retained earnings
Liquid
Securitization
Multiplier-accelerator model
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