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Chapter 15 Interest Rates and the Capital Market Copyright © 2008 Pearson Addison-Wesley. All rights reserved. In this chapter you will learn to 1. Compute the present value of an asset that delivers a stream of future benefits. 2. Explain why the demand for investment is negatively related to the interest rate. 3. Explain why the supply of saving is positively related to the interest rate. 4. Describe how the equilibrium interest rate is determined and how it is affected by various economic events. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-2 A Brief Overview of the Capital Market Investment is the purchase of new capital equipment. It can be financed by: • using retained earnings • borrowing from banks • issuing bonds or stock Firms’ demand for financial capital is derived from their demand for physical capital. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-3 Figure 15.1 The Interaction of Firms and Households in the Capital Market Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-4 Present Value The Present Value of a Single Future Payment Consider purchasing a new capital good: - it produces an MRP of $100 in one year - it produces nothing thereafter - how much are you prepared to pay? If the interest rate is 5% per annum, then the PV is: PV x (1.05) = $100 PV = $95.24 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-5 Table 15.1 The Present Value of a Single Sum One Year in the Future In general, if the interest rate is i percent per year, then the PV of the MRP received one year hence is: PV = MRP/(1 + i) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-6 More Than One Period in the Future What if the MRP occurs t periods in the future? The PV of MRP dollars received t years in the future when the interest rate is i per year is: PV = MRP/(1 + i)t Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-7 Table 15.2 The Present Value of a Single Sum Several Years in the Future Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-8 The Present Value of a Stream of Future Payments The same basic approach is followed: - identify when each MRP occurs - “discount” each MRP back to the present, using the relevant interest rate - sum up the terms from each future period Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-9 Table 15.3 The Present Value of a Stream of Future Payments Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-10 Conclusions 1. Capital is valuable because it generates a stream of future benefits as measured by MRP. 2. The larger is each MRP, or the longer the stream persists, the greater is the PV of the capital. 3. The PV is negatively related to the interest rate. 4. The further ahead in time the MRP occurs, the lower is the PV. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-11 The Demand for Capital The Firm’s Demand for Capital A profit-maximizing firm buys an additional unit of capital if its PV exceeds the purchase price. The firm’s optimal capital stock is such that the PV of the flow of MRPs that is generated by the last unit of capital is equal to its purchase price. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-12 Figure 15.2 The Firm’s Optimal Capital Stock The firm’s optimal capital stock is inversely related to the interest rate. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-13 Figure 15.3 The Interest Rate and the Firm’s Investment Demand Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-14 Figure 15.4 The Economy’s Supply of Saving Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-15 The Supply of Capital Saving and Current Income Household saving is typically positively related to current income. An increase in current income increases desired saving (and thus increases the supply of financial capital). Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-16 Saving and Expected Future Income An increase in expected future income: - increases current consumption reduces current saving Saving and the Interest Rate An increase in the interest rate causes households to: - reduce their current consumption increases their current saving Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-17 The Economy’s Supply of Saving The economy’s supply of saving shows a positive relationship between the interest rate and the quantity of saving supplied. S What causes S to shift? 1. A rise in current income S shifts to right 2. A rise in future income S shifts to left Flow of Saving Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-18 Investment, Saving, and the Interest Rate Individuals firms and households take the interest rate as exogenous, but for the overall economy, the interest rate is endogenous. What is the difference between nominal and real interest rates? EXTENSIONS IN THEORY 15.1 Inflation and Interest Rates Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-19 Figure 15.5 The Market for Financial Capital Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-20 Figure 15.6 Changes in Demand and Supply in the Market for Financial Capital Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-21 Increases in the Supply of Financial Capital Three possible causes of an increase in the supply of saving: 1. income growth 2. population growth 3. government policies – e.g., IRA accounts Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-22 Increases in the Supply of Financial Capital Three possible causes of increased investment demand: 1. income and population growth 2. technological improvements that increase MRP 3. government policies – e.g., investment tax credits Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-23 Figure 15.7 The Capital Stock and Real Interest Rate, 1965–2005 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-24 Globalized Capital Markets APPLYING ECONOMIC CONCEPTS 15.1 Investment and Saving in Globalized Capital Markets Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 15-25