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Macroeconomics: Principles, Applications, and Tools Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 1 of 21 O’Sullivan, Sheffrin, Perez 6/e. Macroeconomics: Principles, Applications, and Tools Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 2 of 21 O’Sullivan, Sheffrin, Perez 6/e. 6/e. O’Sullivan, Sheffrin, Perez Macroeconomics: Principles, Applications, and Tools Investment and Financial Markets After the end of the high tech boom and the sharp decline in the stock market in 2000, individuals and firms began looking for other areas to invest and earn high returns. PREPARED BY FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 3 of 21 12.1 AN INVESTMENT: A PLUNGE INTO THE UNKNOWN Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets • accelerator theory The theory of investment that says that current investment spending depends positively on the expected future growth of real GDP. FIGURE 12.1 Investment Spending as a Share of U.S. GDP, 1970–2007 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 4 of 21 Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 5 of 21 12.1 AN INVESTMENT: A PLUNGE INTO THE UNKNOWN Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets • 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 6 of 21 12.2 EVALUATING THE FUTURE Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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. K present value = (1 i)t P R I N C I P L E O F O P P O RT U N I T Y C O S T The opportunity cost of something is what you sacrifice to get it. 1 2 3 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. 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.” 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 7 of 21 Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets APPLICATION 2 OPTIONS FOR A LOTTERY WINNER APPLYING THE CONCEPTS #2: How can understanding the concept of present value help a lucky lottery winner? The lucky winner of a lottery was given an option: • Receive $1 million a year for 20 years • Receive $10 million today Why would anyone take the $10 million today? To determine which payment option is best, our lottery winner would first need to: • Calculate the present value of $1 million for each of the 20 years • Add up the result • Compare it to the $10 million being offered to her today Example: With an 8 percent interest rate, the present value of an annual payment of $1 million every year for 20 years is $9.8 million. Best option: If interest rates exceed 8 percent, it is better to take the $10 million dollars. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 8 of 21 12.2 EVALUATING THE FUTURE Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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 inflation rate. real rate nominal rate inflation rate Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 9 of 21 12.2 EVALUATING THE FUTURE Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets Real and Nominal Interest Rates • expected real interest rate The nominal interest rate minus the expected inflation rate. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 10 of 21 Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets APPLICATION 3 INTEREST RATES VARY BY RISK AND LENGTH OF LOAN APPLYING THE CONCEPTS #3: Why are there different types of interest rates in the economy? FIGURE 12.2 Interest Rates on Corporate and Government Investments, 2002-2007 Riskier loans and loans for longer maturities typically have higher interest rates. Notice that rates for corporate bonds are higher than the rates for 10-year Treasury bonds. The reason is that corporations are less likely to pay back their loans than the U.S. government. Notice, too, that for most of this time period, the U.S. government typically paid a lower rate when it borrowed for shorter periods of time (six months) than for longer periods of time (10 years). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 11 of 21 12.3 UNDERSTANDING INVESTMENT DECISIONS Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets FIGURE 12.3 The Relationship between Real Interest Rates, and Investment Spending 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 12 of 21 12.3 UNDERSTANDING INVESTMENT DECISIONS Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 13 of 21 12.3 UNDERSTANDING INVESTMENT DECISIONS Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets FIGURE 12.4 The Stock Market and Investment Levels, 1997–2003 Both the stock market and investment spending rose sharply from 1997, peaking in mid-2000. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 14 of 21 12.4 Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT • liquid Easily convertible into money on short notice. FIGURE 12.5 Savers and Investors Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 15 of 21 Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT 12.4 • financial intermediaries Organizations that receive funds from savers and channel them to investors. FIGURE 12.6 Financial Intermediaries Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 16 of 21 12.4 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets • securitization The practice of purchasing loans, repackaging them, and selling them to the financial markets. • leverage Using borrowed funds to purchase assets. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 17 of 21 12.4 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 18 of 21 Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 19 of 21 KEY TERMS Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. CHAPTER 12 Investment and Financial Markets 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 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 20 of 21