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Investment, Saving, and the
Real Interest Rate
CHAPTER
10
EYE ONS
Bond
Stock
Saving
Investment demand
Gross investment
Net investment
Financial capital
Physical capital
Disposable income
Crowding-out-effect
Saving supply
Wealth
Bond market
Financial market
Stock market
DEFINITION
Physical Capital
Tools, instruments, machines, buildings, and other
items produced in the past used to produce goods and
services.
Financial Capital
Funds firms use to buy and operate physical capital
Gross Investment
Total amount spent on new capital goods
Net Investment
Change in quantity of capital
NI = GI - Depreciation
DEFINITION
DEFINITION
Wealth
Value of ALL the things that a person owns..
Savings
Amount of income NOT paid in taxes OR spent on
consumption goods and services
MARKETS for FINANCIAL CAPITAL
Stock Market
Bond Market
Short-Term Securities Market
Loan Market
PHYSICAL and FINANCIAL CAPITAL
Stock Market
Stock certificate of ownership and claim to the profits that a firm makes.
Stock market financial market where shares of companies’ stocks are traded.
Bond Market
Bond promise to pay specified sums of money on specified dates; it is a debt
for the issuer.
Bond market financial market where bonds issued by firms and governments
are traded
• Firms often issue ST bonds as a way to get paid for sales before the
buyer pays
• Mortgage Backed Securities is a type of bond
Short-Term Securities Market
Commercial and Treasury bills—promises by large firms and government to
pay an agreed sum 90 days in the future.
PHYSICAL and FINANCIAL CAPITAL
Loan Market
Banks and other financial institutions lower the cost of financing firms’ capital
expenditures by accepting short-term deposits and making longer-term loans.
Households – Purchase big ticket items
Businesses – Short Term loans to

1. Buy inventories,

2. Extend credit to customers
FINANCIAL INSTITUTIONS and MARKETS
Finance Markets
Financial Institution = Firm that operates on both sides of the market
Key Financial Institutions
• Investment Banks
• Commercial Banks
• Government Sponsored mortgage lenders
• Pension funds
• Insurance Companies
GLOBAL FINANCIAL MARKET
Risk
Loan may not be repaid
Price of a stock or bond might fall
Riskier the loan = higher is the interest rate.
Risk vs Rate
Lenders want to earn the highest possible RIR
Borrowers want to pay the lowest possible RIR
Lenders and Borrowers will go anywhere in WORLD 
GLOBAL FINANCIAL MARKET
Aggregate of ALL INDIVIDUAL Financial Markets 
Loanable Funds Market
INSOLVENCY and ILLIQUIDITY
Net Worth =
Total Market Value – borrowed amount
Solvent Firm
Firm with a positive net worth
Insolvent Firm
Firm with a negative net worth
- When assets are sold and debts are paid the owners
(stockholders) pay the price
Illiquid Firm
Has made long-term loans with borrowed funds AND
Is faced with sudden demand to repay amount larger than
cash on hand
• Normally this firm would borrow from another institution
but if all cash is drying up they go bankrupt.
INTEREST RATE and ASSET PRICES
Financial Assets
Stocks, bonds, short-term securities, and loans
Interest Rate
Percentage of the price of the asset
Thus, Asset Price h = Interest Rate i
and vice versa
LOANABLE FUNDS MARKET
LF USED FOR (DEMAND)
•
•
•
Business Investment
Government Budget Deficit
International Investment and
Lending
Quantity of LF demanded
Depends on: RIR and Expected Profit
Firms: Compare RIR with expected profit on new capital investment decisions
h RIR = i Qty LF demanded
Changes in DLF (shifts)
Happens when: Expected Profit Changes
h Exp. Profit = h amt. invested = h DLF
• Objective Influences:
Business cycle, Technological change, Population growth
• Subjective Influences (Keynes): “animal spirits”
• Contagion Effects (Greenspan): “irrational exuberance”
Investment decision Forward looking, based on subjective feelings
Optimism = h Investment
Pessimism = i Investment
LOANABLE FUNDS MARKET
LF COME FROM (SUPPLY)
•
•
•
Private Savings (largest part)
• RIR
• Disposable Income
• Wealth
• Expected Future income
Government Budget Surplus
International Borrowing
Quantity of LF supplied
Depends on: Mostly Savings depends on RIR, Disp.Inc., Wealth, Exp.Fut.Inc.
Firms: Compare RIR with expected profit on new capital investment decisions
h RIR = h Savings = h Qty LF supplied
Changes in SLF (shifts)
•
•
•
•
Disposable Income
Wealth
Expected Future Income
Default Risk
h Disp. Inc. = h savings
h wealth = i savings
h Exp.Fut.Inc. = i savings
h Default Risk = i savings
LOANABLE FUNDS MARKET
SHIFTS
LOANABLE FUNDS MARKET
Surplus, Shortage
Effects of Shifts
GOVERNMENT in the LOANABLE FUNDS MARKET
GDP  Y = C+I+G+NX; (Expenditure) [NX is 0 globally]
GDP  Y = C+S+NT; (Total Income)
C+I+G+NX = C+S+NT
I+G = S+NT
I = S+NT-G
Investment is financed by Private Savings and Govt. Savings
Total Savings = Private Savings + Govt. Savings
Govt. Surplus  adds to private savings
Govt. Deficit  takes away from private savings 
decreases amount available for investment
SLF = PSLF + GSLF
h SLF  iRIR  iqty private funds & hqty investment and qty demand
GOVERNMENT in the LOANABLE FUNDS MARKET
Crowding-out-effect
Tendency for government budget deficit to raise the real interest rate
and decrease investment
SURPLUS
DEFICIT
GOVERNMENT IN LOANABLE FUNDS MARKET
The Ricardo-Barro Effect
–The proposition that a government budget deficit has
no effect on the real interest rate or investment.
–The Ricardo-Barro effect operates if private saving and
the private supply of loanable funds increase to offset
any government budget deficit so that the total supply of
loanable funds is unchanged when the government has
a budget deficit.
–Most economists regard this outcome unlikely.
FORMULAS
NI = GI - Depreciation
Asset Price h = Interest Rate i
DLF
hRIR = i Qty LF demandedh
hExp. Profit = h amt. invested = h DLF
hOptimism = h Investment & Pessimism = i Investment
SLF
hRIR = h Savings = h Qty LF supplied
h Disp. Inc. = h savings
h wealth = i savings
h Exp.Fut.Inc. = i savings
SLF = PSLF + GSLF
DLF = PDLF + GDLF
EYE on the
FINANCIAL
PAST CRISIS
What Created the Global Financial Crisis?
Events in the market for loanable funds, on both the
supply side and demand side, created the global
financial crisis.
An increase in default risk decreased the supply of
loanable funds.
The disappearance of some major Wall Street
institutions and lowered profit expectations decreased
the demand for loanable funds.
These institutions include Bear Stearns, Lehman
Brothers, Fannie Mae and Freddie Mac, Merrill Lynch,
and AIG.
EYE on the
FINANCIAL
PAST CRISIS
What Created the Global Financial Crisis?
But what caused the increase in default risk and the
failure of so many financial institutions?
Between 2002 and 2005, interest rates were low. There
were plenty of willing borrowers and plenty of willing
lenders.
Fuelled by easy loans, home prices rose rapidly.
Lenders bundled their loans into mortgage-backed
securities and sold them to eager buyers around the
world.
EYE on the
FINANCIAL
PAST CRISIS
What Created the Global Financial Crisis?
Then, in 2006, interest rates began to rise and home
prices began to fall.
People defaulted on mortgages and banks took losses.
Some banks became insolvent.
A downward spiral of lending was under way.
EYE on the U.S. ECONOMY
Did the Rescue Plan Crowd Out Investment?
In mid-2007, on the eve of the onset of the global
financial crisis, U.S. investment expenditure was $2.2
trillion.
The government had a budget deficit of $0.2 trillion.
So the quantity of loanable funds demanded and
supplied was $2.4 trillion.
The real interest rate was 3 percent a year.
By mid-2009, U.S. investment expenditure had fallen to
$1.5 trillion.
The real interest rate had risen to 4.5 percent a year.
EYE on the U.S. ECONOMY
Did the Rescue Plan Crowd Out Investment?
What caused the collapse of investment and the rise
in the real interest rate?
During 2008 and 2009, government rescue-plan
outlays boosted the federal budget deficit by $1
trillion.
In 2009, the budget deficit reached $1.2 trillion.
To finance this deficit, the government issued bonds
and the demand for loanable funds increased by $1
trillion.
EYE on the U.S. ECONOMY
Did the Rescue Plan Crowd Out Investment?
In 2007, the real interest
rate was 3 percent a year.
The government budget
deficit was $0.2 trillion.
Private investment was
$2.2 trillion.
EYE on the U.S. ECONOMY
Did the Rescue Plan Crowd Out Investment?
The rescue-plan
expenditures increased
the demand for loanable
funds.
The real interest rate rose
to 4.5 percent a year.
The higher interest rate
decreased private
investment to $1.5 trillion.
Without the rescue plan,
depressed profit
expectations might have
EYE on YOUR LIFE
Your Participation in the Loanable
Funds Market
Think about the amount of saving that you do.
How much of your disposable income do you save? Is it a
positive amount or a negative amount?
If you save a positive amount, what do you do with your
savings?
Do you put them in a bank, in the stock market, in bonds,
or just keep money at home?
What is the interest rate you earn on your savings?
EYE on YOUR LIFE
Your Participation in the Loanable
Funds Market
If you save a negative amount, just what does that mean?
It means that you have a deficit (like a government deficit).
You’re spending more than your disposable income.
In this case, how do you finance your deficit? Do you get a
student loan? Do you run up an outstanding credit card
balance?
How much do you pay to finance your negative saving
(your dissaving)?
How do you think your saving will change when you
graduate and get a better-paying job?
EYE on YOUR LIFE
Your Participation in the Loanable
Funds Market
Also think about the amount of investment that you do.
You are investing in your human capital by being in school.
What is this investment costing you? How are you
financing this investment?
When you graduate, you will need to decide whether to
invest in an apartment or a house or to rent your home.
How would you make a decision whether to buy or rent a
home?
Would it be smart to borrow $300,000 to finance the
purchase of a home? How would the interest rate influence
your decision?
Investment and
Capital: 1976-2006
Part (a) shows gross
investment and depreciation.
The gap between gross
investment and depreciation
is net investment.
Part (b) shows net
investment.
Part (c) shows the capital
stock.
Investment and
Capital: 1976-2006
Gross investment increases in
most years and increased
rapidly during the booming
1990s, but it decreases in
recession years—see part (a)
of the figure.
Recession years are
highlighted in red.
Investment and
Capital: 1976-2006
Depreciation increases in most
years.
Like gross investment, net
investment increased rapidly
during the 1990s expansion.
Because net investment is
always positive, the quantity of
capital increases each year
despite huge swings in net
investment because the
quantity of capital is large in
comparison to net investment.
Interest Rate Puzzle
The real interest rate paid by big corporations fell from 5.5
percent a year in 2001 to 2.5 percent a year in 2005.
Alan Greenspan said he was puzzled that the real interest
rate was falling when the U.S. government budget deficit
was growing.
Why did the real interest rate fall?
The answer lies in the global loanable funds market.
Interest Rate Puzzle
Global saving increased
and the supply of loanable
funds increased from SLF01
in 2001 to SLF05 in 2005.
U.S. saving decreased and
U.S. borrowing from the
rest of the world increased
strongly during these years.
The Chinese, Japanese,
and Germans all have
much higher saving rates
than do Americans.