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A Lecture Presentation to accompany Exploring Economics 3 Edition by Robert L. Sexton rd Copyright © 2005 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, 3rd Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-324-26086-5 Copyright © 2002 by Thomson Learning, Inc. Chapter 20 Investment and Saving Copyright © 2002 by Thomson Learning, Inc. 20.1 Financial Markets How do households, businesses, and government determine their levels of investment and saving? What role do financial markets play in determining the quantity of capital and the real interest rate? Copyright © 2002 by Thomson Learning, Inc. Financial Markets Financial markets facilitate the interaction between households, firms, governments, banks, and other financial institutions that borrow and lend funds. In financial markets, households are the suppliers of funds and firms are the demanders. Copyright © 2002 by Thomson Learning, Inc. Government is a demander when it is running a budget deficit and a supplier when it is running a budget surplus. Banks and other financial institutions coordinate the plans of lenders and borrowers. The interest rate is determined in the financial markets. Copyright © 2002 by Thomson Learning, Inc. Financial markets are global. The two most important financial markets are: the stock market the bond market Copyright © 2002 by Thomson Learning, Inc. Stocks The owners of corporations own shares of stock in the company and are called stockholders. Each stockholder's ownership of the corporation and voting rights in the selection of corporate management is proportionate to the number of shares owned. Copyright © 2002 by Thomson Learning, Inc. Shares of stock are bought and sold by individuals and institutions in the stock market, usually on one of the organized stock exchanges. The price that shares sell for will fluctuate (often many times a day) with changes in demand and/or supply. Copyright © 2002 by Thomson Learning, Inc. Corporations sometimes use proceeds from new sales of stock to finance expansion of their activities. Two primary types of stock preferred stock common stock Copyright © 2002 by Thomson Learning, Inc. Preferred stock Owners receive a fixed regular dividend payment; the payment remains the same regardless of the profits of the corporation. No dividends can generally be paid to holders of common stock until the preferred stockholders receive a specified fixed amount per share of stock, assuming that funds are available after the debts of the corporation are paid. Copyright © 2002 by Thomson Learning, Inc. Common stock Owners are residual claimants. Share in profits after expenses are paid, including interest payments to debt obligations and dividend payments to preferred stock. If corporation is sold or liquidated, receive assets after all debts are paid and preferred stockholders are paid a fixed amount per share. Dividends frequently vary with profits. Copyright © 2002 by Thomson Learning, Inc. Owners of common stock assume greater risks than preferred stockholders, doing so because the potential rewards are then greater if the company is in fact successful. Copyright © 2002 by Thomson Learning, Inc. Who Owns Stock In U.S. Corporations? Individuals as well as institutions such as insurance companies, pension funds, mutual funds, trust departments of banks, and university and foundation endowment funds, all hold corporate stocks. General Motors, IBM, and Microsoft have millions of individual stockholders. Copyright © 2002 by Thomson Learning, Inc. Indirectly, millions more are involved in stocks through their interest in mutual funds, ownership of life insurance, vested rights in private pension funds, and so on. Copyright © 2002 by Thomson Learning, Inc. Corporations obtain some of their initial financial capital (dollars used to buy capital goods) by selling stock. Growth in the financial resources reinvesting profits that are earned in the business selling new shares of stock borrowing money Copyright © 2002 by Thomson Learning, Inc. Bonds While corporate borrowing takes different forms, corporations primarily borrow by issuing bonds. The holder of a bond is not a part owner of a corporation; rather, he is a creditor to whom the corporation has a debt obligation. Copyright © 2002 by Thomson Learning, Inc. The obligation to bondholders is of higher legal priority than that of stockholders. Before any dividends can be paid, even to owners of preferred stock, the interest obligations to bondholders must be met. If a company is liquidated, bondholders must be paid in full the face value of their bond holding before any disbursements can be made to stockholders. Copyright © 2002 by Thomson Learning, Inc. Bondholders have greater financial security than stockholders, but receive a fixed annual interest payment, with no possibility to receive increased payments as the company prospers. The possibility of the value of a bond increasing greatly—a capital gain—is limited compared to that of stocks. Copyright © 2002 by Thomson Learning, Inc. A company can get finances through plowbacks or reinvestment. Instead of using their profits to pay out dividends, a firm might take some of its profits and plow it back into the company for new capital equipment. Copyright © 2002 by Thomson Learning, Inc. Refinancing is by far the most important source of funding—almost 65 percent of a firm’s finances come from reinvestment. Attractive to firms as a source of funds because issuing new stocks and bonds can be an expensive and lengthy process. Copyright © 2002 by Thomson Learning, Inc. The Stock Market The two most important financial markets where savers can provide funds to borrowers are the stock market and the bond market. The values of securities (stocks and bonds) sold in financial markets change with expectations of benefits and costs. Copyright © 2002 by Thomson Learning, Inc. Expected corporate earnings, business conditions, the economic policies of the government, business conditions in foreign countries, and concern over inflation all influence the price of stocks (and, to a lesser extent, bonds). Copyright © 2002 by Thomson Learning, Inc. During periods of rising securities markets, optimism is generally great, and businesses are more likely to invest in new capital equipment, perhaps financing it by selling new shares of stock at current high prices. Copyright © 2002 by Thomson Learning, Inc. During periods of pessimism, stock prices fall, and businesses reduce expenditures on new capital equipment, partly because financing such equipment by stock sales is more costly. More shares have to be sold to get a given amount of cash, seriously diluting the ownership interest of existing stockholders. Copyright © 2002 by Thomson Learning, Inc. Economists consider the stock market a random walk. Without illegal inside information or a lot of luck, it is very difficult to consistently pick winners in the stock market. Copyright © 2002 by Thomson Learning, Inc. Hot tips are only hot if you are one of only a few to know if a company's stock is going to rise. Once that news hits the street, it will cease to be a source of profit. In sum, if markets are operating efficiently, the current stock prices will reflect all available information, and consistent, extraordinary profit opportunities will not exist. Copyright © 2002 by Thomson Learning, Inc. Many financial analysts think that the best stock market strategy is to diversify, buying several different stocks, and holding them for long periods. You don't have to continue to pay commissions on additional trades. The stock market has historically outperformed other financial assets. Copyright © 2002 by Thomson Learning, Inc. Reading Stock Tables Most newspapers (and many Web sites) have a financial section that covers the prices of stocks so investors can have some of the information that they need to make their decisions to buy and sell stocks. Some investors watch this data by the second as they are trading in and out of stocks a number of times during the day. Copyright © 2002 by Thomson Learning, Inc. At the other extreme, some investors pick a good company and hold the stock for a long time hoping that it will give them a better return than other assets, like saving accounts. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Wall Street Journal’s stock tables explained: First column shows the stock’s year-todate percentage change Second column shows highest price over the last 52 weeks. Third column shows the stock’s lowest price over the last 52 weeks. Fourth column shows the name and symbol of the stock. Copyright © 2002 by Thomson Learning, Inc. Fifth column shows the dividend annual amount the company has paid over the preceding year on each share of stock. Sixth column shows the yield, the dividend divided by the price of the stock. Seventh column shows the price-earnings (PE) ratio price of the stock divided by the amount the company earned per share over the past year. Copyright © 2002 by Thomson Learning, Inc. Price earnings ratio--measure of how highly a stock is valued. Typical price earnings ratio is around 15. If higher, the stock is relatively expensive in terms of its recent earnings. The stock might be overvalued or investors are expecting share prices to rise in the future. If lower, the stock is either undervalued or investors may expect future earnings to fall. Copyright © 2002 by Thomson Learning, Inc. Eighth column shows the previous trading day’s high for the stock. Ninth column shows the previous trading day’s low for the stock. Tenth column shows the previous trading day’s closing price for the stock. Eleventh column shows the net change in the stock price during the previous trading day. Copyright © 2002 by Thomson Learning, Inc. 20.2 Investment Demand and Saving Supply If we put the investment demand for the whole economy and national savings together, we can establish the real interest rate in the saving and investment market. The investment demand curve (ID) is downward sloping, reflecting the fact that investment spending varies inversely with the real interest rate—the amount borrowers pay for their loans. Copyright © 2002 by Thomson Learning, Inc. At high real interest rates, firms will only pursue those few investment activities with even higher expected rates of return. As the real interest rate falls, additional projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises. Copyright © 2002 by Thomson Learning, Inc. The investment demand curve shows the dollar amount of investment forthcoming at different real interest rate. Because lower interest rates stimulate the quantity of investment demanded, governments often try to combat recessions by lowering interest rates. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Shifting The Investment Demand Curve For a given interest rate, If firms expect higher rates of return on their investments, the ID curve will shift to the right. If firms expect lower rates of return on their investments, the ID curve will shift to the left. Copyright © 2002 by Thomson Learning, Inc. Several determinants other than interest rates will shift the investment demand curve. technology inventory expectations business taxes Copyright © 2002 by Thomson Learning, Inc. Product and process innovation can cause the ID curve to shift out. The development of new machines that can improve the quality and the quantity of products or lower the costs of production will increase the rate of return on investment, independent of the interest rate. The same is true for new products. Copyright © 2002 by Thomson Learning, Inc. Inventories are high. goods are stockpiled in warehouses lower expected rate of return on new investment, Firms with excess inventories of finished goods have little incentive to invest in new capital. so ID shifts to the left. Copyright © 2002 by Thomson Learning, Inc. Inventories are low. firms look to replenish their shelves expected rate of return on new investment increases so ID shifts to the right. Copyright © 2002 by Thomson Learning, Inc. If higher expected sales and a higher profit rate are forecast, firms will invest in plant and equipment and the ID curve shifts to the right. More investment will be desired at a given interest rate. If lower expected sales and a lower profit rate are forecasted, the ID curve shifts to the left. Fewer investments will be desired at a given interest rate. Copyright © 2002 by Thomson Learning, Inc. If business taxes are lowered, potential after-tax profits on investment projects will increase and shift the ID curve to the right. such as with an investment tax credit, Higher business taxes will lead to lower potential after-tax profits on investment projects and shift the ID curve to the left. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. The supply of national saving is composed of both private saving and public saving. Households, firms, and the government can supply savings. The supply curve of savings is upward sloping. At a higher real interest rate, there is a greater quantity of savings supplied. Copyright © 2002 by Thomson Learning, Inc. Think of the interest rate as the reward for saving and supplying funds to financial markets. At a lower real interest rate, a lower quantity of savings is supplied. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. If disposable (after-tax) income rises, the supply of savings shifts to the right; more savings would occur at any given interest rate. falls, the supply of savings shifts to the left; less saving would occur at any given interest rate. Copyright © 2002 by Thomson Learning, Inc. As with the investment demand curve, there are noninterest determinants of the saving supply curve. Expected future earnings lower, you would tend to save more now at any given interest rate shifting the saving supply curve to the right. higher, you would tend to consume more and save less now, knowing that more income is right around the corner shifting the saving supply curve to the left. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. In equilibrium, desired investment equals desired national saving at the intersection of the investment demand curve and the saving supply curve. The real equilibrium interest rate is determined by the intersection of these two curves. If the real interest rate is above the equilibrium real interest rate, forces within the economy would tend to restore the equilibrium. Copyright © 2002 by Thomson Learning, Inc. At a higher than real equilibrium interest rate, the quantity of savings supplied would be greater that quantity of investment demanded; there would be a surplus of savings at this real interest rate. As savers (lenders) compete against each other to attract investment demanders (borrowers), the real interest rate falls. Copyright © 2002 by Thomson Learning, Inc. Alternatively if the real interest rate is below the equilibrium real interest rate, the quantity of investment demanded is greater than the quantity of saving supplied at that interest rate and a shortage of saving occurs. As investment demanders (borrowers) compete against each other for the available saving, the real interest rate is bid up. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Calculating Present Value One of the most important decisions a firm makes is investment in new capital. A lot of money will be invested in factory equipment and machines expected to last for many years. Copyright © 2002 by Thomson Learning, Inc. A firm making an investment decision must consider the price of the new capital that they must pay now with the additional revenue the firm anticipates to make over time. That is, the firm must compare current cost with future benefits. To figure out how much those future benefits are worth today, economists use a concept called present value. Copyright © 2002 by Thomson Learning, Inc. The present value of future income is the value of having that future income now. People prefer to have money now rather than later; that is why they are willing to pay interest to borrow it. PV = $X / (1 + r)t Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Because the discount rate varies from person to person, a good proxy is the market rate of interest. An investor will buy capital if the expected discounted present value of the capital exceeds the current price. Therefore, falling interest rates lead to greater investment. Copyright © 2002 by Thomson Learning, Inc. Government And Financial Markets We have treated the labor, capital, and land markets independently. In reality, these markets are interdependent. For example, if wages rise and/or the rental price of capital falls, machines might be substituted for some workers. Copyright © 2002 by Thomson Learning, Inc. Total output of firms equals the total income of households. GDP (or Y) = C + I + G + (X – M) In a closed economy, net imports are zero because there is no international trade—that is, exports are zero and imports are zero. Copyright © 2002 by Thomson Learning, Inc. (1) (2) (3) (4) (5) Y=C+I+G Y–C -G=I S=I S=Y–C–G S = (Y – T – C) + (T – G) Copyright © 2002 by Thomson Learning, Inc. Private saving is the amount of income households have left over after consumption and net taxes. Public saving is the amount of income the government has left over after paying for its spending. Copyright © 2002 by Thomson Learning, Inc. Let’s see how a budget surplus affects the real interest rate and the amount of saving and investment. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. When the government spends more than it receives in tax revenues, it experiences a budget deficit; the government is actually dissaving (saving negatively or borrowing), which decreases national saving. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. When the real interest rate rises because of the government budget deficit, private investment decreases. Economists call this the crowdingout effect. Copyright © 2002 by Thomson Learning, Inc. Saving And Investment In An Open Economy In an open economy, individuals, firms, and governments are able to borrow from and lend to foreigners. When foreigners supply more funds than they demand, there is a capital inflow. When foreigners demand more funds than they supply, there is a capital outflow. Copyright © 2002 by Thomson Learning, Inc. Copyright © 2002 by Thomson Learning, Inc. Capital outflows to foreign countries reduce the saving supply, reducing the funds available for domestic capital investment and causing the saving supply curve to be positioned to the left of the national saving supply curve. Copyright © 2002 by Thomson Learning, Inc. When the real domestic interest rate is low, capital will flow out to foreign markets where the real interest rate is higher. A higher real domestic interest rate will cause an inflow of capital because foreigners will look for a higher rate of return on their investments. Copyright © 2002 by Thomson Learning, Inc.