investment and saving

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Exploring EconomicsExploring Economics33rdrd Edition Edition

by Robert L. Sextonby Robert L. SextonCopyright © 2005 Thomson Learning, Inc. Copyright © 2005 Thomson Learning, Inc.

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A Lecture PresentationA Lecture Presentation


Investment and SavingInvestment and Saving

Chapter 20Chapter 20


20.1 Financial Markets20.1 Financial Markets

How do households, businesses, and How do households, businesses, and government determine their levels of government determine their levels of investment and saving?investment and saving?

What role do financial markets play What role do financial markets play in determining the quantity of capital in determining the quantity of capital and the real interest rate?and the real interest rate?


Financial MarketsFinancial Markets

Financial markets facilitate the Financial markets facilitate the interaction between households, interaction between households, firms, governments, banks, and other firms, governments, banks, and other financial institutions that borrow and financial institutions that borrow and lend funds.lend funds.

In financial markets, households are In financial markets, households are the suppliers of funds and firms are the suppliers of funds and firms are the demanders.the demanders.


Government is a demander when it Government is a demander when it is running a budget deficit and a is running a budget deficit and a supplier when it is running a budget supplier when it is running a budget surplus.surplus.

Banks and other financial institutions Banks and other financial institutions coordinate the plans of lenders and coordinate the plans of lenders and borrowers.borrowers.

The interest rate is determined in The interest rate is determined in the financial markets.the financial markets.


Financial markets are global.Financial markets are global. The two most important financial The two most important financial

markets are:markets are: the stock marketthe stock market the bond marketthe bond market


StocksStocks

The owners of corporations own The owners of corporations own shares of stock in the company shares of stock in the company and are called and are called stockholdersstockholders..

Each stockholder's ownership of the Each stockholder's ownership of the corporation and voting rights in the corporation and voting rights in the selection of corporate management selection of corporate management is proportionate to the number of is proportionate to the number of shares owned.shares owned.


Shares of stock are bought and sold Shares of stock are bought and sold by individuals and institutions in the by individuals and institutions in the stock market, usually on one of the stock market, usually on one of the organized stock exchanges.organized stock exchanges.

The price that shares sell for will The price that shares sell for will fluctuate (often many times a day) fluctuate (often many times a day) with changes in demand and/or with changes in demand and/or supply.supply.


Corporations sometimes use proceeds Corporations sometimes use proceeds from new sales of stock to finance from new sales of stock to finance expansion of their activities. expansion of their activities.

Two primary types of stockTwo primary types of stock preferred stockpreferred stock common stockcommon stock


Preferred stock Preferred stock Owners receive a fixed regular dividend Owners receive a fixed regular dividend

payment; the payment remains the same payment; the payment remains the same regardless of the profits of the corporation.regardless of the profits of the corporation.

No dividends can generally be paid to No dividends can generally be paid to holders of common stock until the holders of common stock until the preferred stockholders receive a specified preferred stockholders receive a specified fixed amount per share of stock, assuming fixed amount per share of stock, assuming that funds are available after the debts of that funds are available after the debts of the corporation are paid.the corporation are paid.


Common stock Common stock Owners are residual claimants.Owners are residual claimants.

Share in profits after expenses are paid, Share in profits after expenses are paid, including interest payments to debt including interest payments to debt obligations and dividend payments to obligations and dividend payments to preferred stock. preferred stock.

If corporation is sold or liquidated, receive If corporation is sold or liquidated, receive assets after all debts are paid and preferred assets after all debts are paid and preferred stockholders are paid a fixed amount per stockholders are paid a fixed amount per share. share.

Dividends frequently vary with profits.Dividends frequently vary with profits.


Owners of common stock assume Owners of common stock assume greater risks than preferred greater risks than preferred stockholders, doing so because the stockholders, doing so because the potential rewards are then greater if potential rewards are then greater if the company is in fact successful.the company is in fact successful.


Who Owns Stock In U.S. Who Owns Stock In U.S. Corporations?Corporations?

Individuals as well as institutions Individuals as well as institutions such as insurance companies, such as insurance companies, pension funds, mutual funds, trust pension funds, mutual funds, trust departments of banks, and university departments of banks, and university and foundation endowment funds, all and foundation endowment funds, all hold corporate stocks.hold corporate stocks.

General Motors, IBM, and Microsoft General Motors, IBM, and Microsoft have millions of individual have millions of individual stockholders.stockholders.


Indirectly, millions more are involved Indirectly, millions more are involved in stocks through their interest in in stocks through their interest in mutual funds, ownership of life mutual funds, ownership of life insurance, vested rights in private insurance, vested rights in private pension funds, and so on.pension funds, and so on.


Corporations obtain some of their Corporations obtain some of their initial financial capital (dollars used to initial financial capital (dollars used to buy capital goods) by selling stock.buy capital goods) by selling stock.

Growth in the financial resources Growth in the financial resources reinvesting profits that are earned in the reinvesting profits that are earned in the

businessbusiness selling new shares of stockselling new shares of stock borrowing moneyborrowing money


BondsBonds

While corporate borrowing takes While corporate borrowing takes different forms, corporations primarily different forms, corporations primarily borrow by issuing borrow by issuing bondsbonds..

The holder of a bond is not a part The holder of a bond is not a part owner of a corporation; rather, he is owner of a corporation; rather, he is a creditor to whom the corporation a creditor to whom the corporation has a debt obligation.has a debt obligation.


The obligation to bondholders is of The obligation to bondholders is of higher legal priority than that of higher legal priority than that of stockholders. stockholders. Before any dividends can be paid, even Before any dividends can be paid, even

to owners of preferred stock, the interest to owners of preferred stock, the interest obligations to bondholders must be met.obligations to bondholders must be met.

If a company is liquidated, bondholders If a company is liquidated, bondholders must be paid in full the face value of must be paid in full the face value of their bond holding before any their bond holding before any disbursements can be made to disbursements can be made to stockholders.stockholders.


Bondholders have greater financial Bondholders have greater financial security than stockholders, but security than stockholders, but receive a fixed annual interest receive a fixed annual interest payment, with no possibility to payment, with no possibility to receive increased payments as the receive increased payments as the company prospers.company prospers.

The possibility of the value of a bond The possibility of the value of a bond increasing greatly—a capital gain—is increasing greatly—a capital gain—is limited compared to that of stocks. limited compared to that of stocks.


A company can get finances through A company can get finances through plowbacks or reinvestment.plowbacks or reinvestment.

Instead of using their profits to pay Instead of using their profits to pay out dividends, a firm might take some out dividends, a firm might take some of its profits and plow it back into the of its profits and plow it back into the company for new capital equipment.company for new capital equipment.


Refinancing is by far the most Refinancing is by far the most important source of funding—almost important source of funding—almost 65 percent of a firm’s finances come 65 percent of a firm’s finances come from reinvestment. from reinvestment.

Attractive to firms as a source of Attractive to firms as a source of funds because issuing new stocks and funds because issuing new stocks and bonds can be an expensive and bonds can be an expensive and lengthy process.lengthy process.


The Stock MarketThe Stock Market

The two most important financial The two most important financial markets where savers can provide markets where savers can provide funds to borrowers are the stock funds to borrowers are the stock market and the bond market. market and the bond market.

The values of The values of securitiessecurities (stocks and (stocks and bonds) sold in financial markets bonds) sold in financial markets change with expectations of benefits change with expectations of benefits and costs. and costs.


Expected corporate earnings, Expected corporate earnings, business conditions, the economic business conditions, the economic policies of the government, business policies of the government, business conditions in foreign countries, and conditions in foreign countries, and concern over inflation all influence concern over inflation all influence the price of stocks (and, to a lesser the price of stocks (and, to a lesser extent, bonds). extent, bonds).


During periods of rising securities During periods of rising securities markets, optimism is generally great, markets, optimism is generally great, and businesses are more likely to and businesses are more likely to invest in new capital equipment, invest in new capital equipment, perhaps financing it by selling new perhaps financing it by selling new shares of stock at current high prices.shares of stock at current high prices.


During periods of pessimism, stock During periods of pessimism, stock prices fall, and businesses reduce prices fall, and businesses reduce expenditures on new capital equipment, expenditures on new capital equipment, partly because financing such equipment partly because financing such equipment by stock sales is more costly. by stock sales is more costly.

More shares have to be sold to get a More shares have to be sold to get a given amount of cash, seriously diluting given amount of cash, seriously diluting the ownership interest of existing the ownership interest of existing stockholders.stockholders.


Economists consider the stock market Economists consider the stock market a a random walkrandom walk. . Without illegal inside information or a lot Without illegal inside information or a lot

of luck, it is very difficult to consistently of luck, it is very difficult to consistently pick winners in the stock market. pick winners in the stock market.


Hot tips are only hot if you are one of Hot tips are only hot if you are one of only a few to know if a company's stock only a few to know if a company's stock is going to rise. is going to rise.

Once that news hits the street, it will Once that news hits the street, it will cease to be a source of profit. cease to be a source of profit.

In sum, if markets are operating In sum, if markets are operating efficiently, the current stock prices will efficiently, the current stock prices will reflect all available information, and reflect all available information, and consistent, extraordinary profit consistent, extraordinary profit opportunities will not exist. opportunities will not exist.


Many financial analysts think that Many financial analysts think that the best stock market strategy is to the best stock market strategy is to diversify, buying several different diversify, buying several different stocks, and holding them for long stocks, and holding them for long periods. periods. You don't have to continue to pay You don't have to continue to pay

commissions on additional trades. commissions on additional trades. The stock market has historically The stock market has historically

outperformed other financial assets. outperformed other financial assets.


Reading Stock TablesReading Stock Tables

Most newspapers (and many Web sites) Most newspapers (and many Web sites) have a financial section that covers the have a financial section that covers the prices of stocks so investors can have prices of stocks so investors can have some of the information that they need some of the information that they need to make their decisions to buy and sell to make their decisions to buy and sell stocks. stocks.

Some investors watch this data by the Some investors watch this data by the second as they are trading in and out of second as they are trading in and out of stocks a number of times during the stocks a number of times during the day. day.


At the other extreme, some investors At the other extreme, some investors pick a good company and hold the pick a good company and hold the stock for a long time hoping that it stock for a long time hoping that it will give them a better return than will give them a better return than other assets, like saving accounts. other assets, like saving accounts.


Wall Street JournalWall Street Journal’s stock tables ’s stock tables explained:explained: First column shows the stock’s year-to-First column shows the stock’s year-to-

date percentage changedate percentage change Second column shows highest price over Second column shows highest price over

the last 52 weeks. the last 52 weeks. Third column shows the stock’s lowest Third column shows the stock’s lowest

price over the last 52 weeks.price over the last 52 weeks. Fourth column shows the name and Fourth column shows the name and

symbol of the stock. symbol of the stock.


Fifth column shows the Fifth column shows the dividenddividend annual amount the company has paid over annual amount the company has paid over

the preceding year on each share of stock.the preceding year on each share of stock. Sixth column shows the yield, the dividend Sixth column shows the yield, the dividend

divided by the price of the stock.divided by the price of the stock. Seventh column shows the Seventh column shows the price-earnings price-earnings

(PE) ratio(PE) ratio price of the stock divided by the amount the price of the stock divided by the amount the

company earned per share over the past company earned per share over the past year.year.


Price earnings ratio-Price earnings ratio--measure of -measure of how highly a stock is valued. how highly a stock is valued. Typical price earnings ratio is around 15. Typical price earnings ratio is around 15.

If higher, the stock is relatively expensive in If higher, the stock is relatively expensive in terms of its recent earnings. terms of its recent earnings.

The stock might be overvalued orThe stock might be overvalued or investors are expecting share prices to rise in the investors are expecting share prices to rise in the

future. future. If lower, the stock is either undervalued or If lower, the stock is either undervalued or

investors may expect future earnings to fall. investors may expect future earnings to fall.


Eighth column shows the previous trading Eighth column shows the previous trading day’s high for the stock.day’s high for the stock.

Ninth column shows the previous trading Ninth column shows the previous trading day’s low for the stock. day’s low for the stock.

Tenth column shows the previous trading Tenth column shows the previous trading day’s closing price for the stock.day’s closing price for the stock.

Eleventh column shows the net change in Eleventh column shows the net change in the stock price during the previous trading the stock price during the previous trading day.day.


20.2 Investment Demand and20.2 Investment Demand and Saving Supply Saving Supply

If we put the investment demand for If we put the investment demand for the whole economy and national the whole economy and national savings together, we can establish savings together, we can establish the real interest rate in the saving the real interest rate in the saving and investment market. and investment market.

The investment demand curve (The investment demand curve (IDID) is ) is downward sloping, reflecting the fact downward sloping, reflecting the fact that investment spending varies that investment spending varies inversely with the real interest rate—the inversely with the real interest rate—the amount borrowers pay for their loans. amount borrowers pay for their loans.


At high real interest rates, firms will At high real interest rates, firms will only pursue those few investment only pursue those few investment activities with even higher expected activities with even higher expected rates of return. rates of return.

As the real interest rate falls, As the real interest rate falls, additional projects with lower additional projects with lower expected rates of return become expected rates of return become profitable for firms, and the quantity profitable for firms, and the quantity of investment demanded rises. of investment demanded rises.


The investment demand curve shows The investment demand curve shows the dollar amount of investment the dollar amount of investment forthcoming at different real interest forthcoming at different real interest rate.rate.

Because lower interest rates stimulate Because lower interest rates stimulate the quantity of investment the quantity of investment demanded, governments often try to demanded, governments often try to combat recessions by lowering combat recessions by lowering interest rates.interest rates.


Shifting The Investment Shifting The Investment Demand CurveDemand Curve

For a given interest rate,For a given interest rate, If firms expect higher rates of return on If firms expect higher rates of return on

their investments, the their investments, the IDID curve will shift curve will shift to the right.to the right.

If firms expect lower rates of return on If firms expect lower rates of return on their investments, the their investments, the IDID curve will shift curve will shift to the left.to the left.


Several determinants other than Several determinants other than interest rates will shift the investment interest rates will shift the investment demand curve. demand curve. technology technology inventoryinventory expectations expectations business taxes business taxes


Product and process innovation can Product and process innovation can cause the ID curve to shift out. cause the ID curve to shift out. The development of new machines that The development of new machines that

can improve the quality and the quantity can improve the quality and the quantity of products or lower the costs of of products or lower the costs of production will increase the rate of return production will increase the rate of return on investment, independent of the on investment, independent of the interest rate. The same is true for new interest rate. The same is true for new products.products.


Inventories are high.Inventories are high. goods are stockpiled in warehouses goods are stockpiled in warehouses lower expected rate of return on new lower expected rate of return on new

investment, investment, Firms with excess inventories of finished Firms with excess inventories of finished

goods have little incentive to invest in new goods have little incentive to invest in new capital. capital.

so so IDID shifts to the left. shifts to the left.


Inventories are low.Inventories are low. firms look to replenish their shelves firms look to replenish their shelves expected rate of return on new expected rate of return on new

investment increasesinvestment increases so so IDID shifts to the right. shifts to the right.


If higher expected sales and a higher profit If higher expected sales and a higher profit rate are forecast, firms will invest in plant rate are forecast, firms will invest in plant and equipment and the and equipment and the IDID curve shifts to curve shifts to the right. the right. More investment will be desired at a More investment will be desired at a

given interest rate.given interest rate. If lower expected sales and a lower profit If lower expected sales and a lower profit

rate are forecasted, the rate are forecasted, the IDID curve shifts to curve shifts to the left.the left. Fewer investments will be desired at a Fewer investments will be desired at a

given interest rate.given interest rate.


If business taxes are lowered, If business taxes are lowered, potential after-tax profits on potential after-tax profits on investment projects will increase and investment projects will increase and shift the shift the IDID curve to the right. curve to the right. such as with an investment tax credit, such as with an investment tax credit,

Higher business taxes will lead to Higher business taxes will lead to lower potential after-tax profits on lower potential after-tax profits on investment projects and shift the investment projects and shift the IDID curve to the left.curve to the left.


The supply of The supply of national savingnational saving is is composed of both private saving and composed of both private saving and public saving. public saving. Households, firms, and the Households, firms, and the

government can supply savings.government can supply savings. The supply curve of savings is upward The supply curve of savings is upward

sloping.sloping. At a higher real interest rate, there is a At a higher real interest rate, there is a

greater quantity of savings supplied.greater quantity of savings supplied.


Think of the interest rate as the Think of the interest rate as the reward for saving and supplying funds reward for saving and supplying funds to financial markets.to financial markets.

At a lower real interest rate, a lower At a lower real interest rate, a lower quantity of savings is supplied.quantity of savings is supplied.


If disposable (after-tax) incomeIf disposable (after-tax) income rises, the supply of savings shifts to the rises, the supply of savings shifts to the

right; more savings would occur at any right; more savings would occur at any given interest rate. given interest rate.

falls, the supply of savings shifts to the falls, the supply of savings shifts to the left; less saving would occur at any given left; less saving would occur at any given interest rate. interest rate.


As with the investment demand curve, there As with the investment demand curve, there are noninterest determinants of the saving are noninterest determinants of the saving supply curve. supply curve.

Expected future earningsExpected future earnings lower, you would tend to save more now at any lower, you would tend to save more now at any

given interest rate shifting the saving supply given interest rate shifting the saving supply curve to the right. curve to the right.

higher, you would tend to consume more and higher, you would tend to consume more and save less now, knowing that more income is right save less now, knowing that more income is right around the corner shifting the saving supply around the corner shifting the saving supply curve to the left.curve to the left.


In equilibrium, In equilibrium, desired investment equals desired national desired investment equals desired national

saving at the intersection of the investment saving at the intersection of the investment demand curve and the saving supply curve. demand curve and the saving supply curve.

The real equilibrium interest rate is The real equilibrium interest rate is determined by the intersection of these determined by the intersection of these two curves.two curves.

If the real interest rate is above the If the real interest rate is above the equilibrium real interest rate, forces within equilibrium real interest rate, forces within the economy would tend to restore the the economy would tend to restore the equilibrium. equilibrium.


At a higher than real equilibrium interest At a higher than real equilibrium interest rate, the quantity of savings supplied rate, the quantity of savings supplied would be greater that quantity of would be greater that quantity of investment demanded; there would be a investment demanded; there would be a surplus of savings at this real interest surplus of savings at this real interest rate. rate.

As savers (lenders) compete against As savers (lenders) compete against each other to attract investment each other to attract investment demanders (borrowers), the real interest demanders (borrowers), the real interest rate falls. rate falls.


Alternatively if the real interest rate is Alternatively if the real interest rate is below the equilibrium real interest rate, below the equilibrium real interest rate, the quantity of investment demanded the quantity of investment demanded is greater than the quantity of saving is greater than the quantity of saving supplied at that interest rate and a supplied at that interest rate and a shortage of saving occurs.shortage of saving occurs.

As investment demanders (borrowers) As investment demanders (borrowers) compete against each other for the compete against each other for the available saving, the real interest rate available saving, the real interest rate is bid up.is bid up.


Calculating Present ValueCalculating Present Value

One of the most important decisions One of the most important decisions a firm makes is investment in new a firm makes is investment in new capital.capital.

A lot of money will be invested in A lot of money will be invested in factory equipment and machines factory equipment and machines expected to last for many years.expected to last for many years.


A firm making an investment decision A firm making an investment decision must consider the price of the new capital must consider the price of the new capital that they must pay now with the that they must pay now with the additional revenue the firm anticipates additional revenue the firm anticipates to make over time. to make over time.

That is, the firm must compare current That is, the firm must compare current cost with future benefits. cost with future benefits.

To figure out how much those future To figure out how much those future benefits are worth today, economists benefits are worth today, economists use a concept called use a concept called present valuepresent value..


The present value of future income The present value of future income is the value of having that future is the value of having that future income now. income now.

People prefer to have money now People prefer to have money now rather than later; that is why they are rather than later; that is why they are willing to pay interest to borrow it.willing to pay interest to borrow it.

PVPV = $ = $XX / (1 + / (1 + rr))tt


Because the discount rate varies from Because the discount rate varies from person to person, a good proxy is the person to person, a good proxy is the market rate of interest.market rate of interest.

An investor will buy capital if the An investor will buy capital if the expected discounted present value of expected discounted present value of the capital exceeds the current price. the capital exceeds the current price.

Therefore, falling interest rates lead Therefore, falling interest rates lead to greater investment.to greater investment.


Government And Financial Government And Financial MarketsMarkets

We have treated the labor, capital, We have treated the labor, capital, and land markets independently. and land markets independently.

In reality, these markets are In reality, these markets are interdependent.interdependent.

For example, if wages rise and/or the For example, if wages rise and/or the rental price of capital falls, machines rental price of capital falls, machines might be substituted for some might be substituted for some workers.workers.


Total output of firms equals the total Total output of firms equals the total income of households.income of households.

GDP (or GDP (or YY) = ) = C + I + G + (X – M)C + I + G + (X – M) In a In a closed economyclosed economy, net imports , net imports

are zero because there is no are zero because there is no international trade—that is, exports international trade—that is, exports are zero and imports are zero.are zero and imports are zero.


(1) (1) Y = C + I + GY = C + I + G (2)(2) Y – C - G = I Y – C - G = I (3)(3) S = I S = I (4)(4) S = Y – C – G S = Y – C – G (5)(5) S = (Y – T – C) + (T – G) S = (Y – T – C) + (T – G)


Private savingPrivate saving is the amount of is the amount of income households have left over income households have left over after consumption and net taxes.after consumption and net taxes.

Public savingPublic saving is the amount of is the amount of income the government has left income the government has left over after paying for its spending.over after paying for its spending.


Let’s see how a budget surplus affects Let’s see how a budget surplus affects the real interest rate and the amount the real interest rate and the amount of saving and investment.of saving and investment.


When the government spends more When the government spends more than it receives in tax revenues, it than it receives in tax revenues, it experiences a budget deficit; the experiences a budget deficit; the government is actually government is actually dissavingdissaving (saving negatively or borrowing), (saving negatively or borrowing), which decreases national saving.which decreases national saving.


When the real interest rate rises When the real interest rate rises because of the government budget because of the government budget deficit, private investment decreases.deficit, private investment decreases.

Economists call this the Economists call this the crowding-crowding-out effectout effect..


Saving And Investment In An Saving And Investment In An Open EconomyOpen Economy

In an open economy, individuals, In an open economy, individuals, firms, and governments are able to firms, and governments are able to borrow from and lend to foreigners.borrow from and lend to foreigners.

When foreigners supply more funds When foreigners supply more funds than they demand, there is a capital than they demand, there is a capital inflow.inflow.

When foreigners demand more funds When foreigners demand more funds than they supply, there is a capital than they supply, there is a capital outflow.outflow.


Capital outflows to foreign countries Capital outflows to foreign countries reduce the saving supply, reducing reduce the saving supply, reducing the funds available for domestic the funds available for domestic capital investment and causing the capital investment and causing the saving supply curve to be positioned saving supply curve to be positioned to the left of the national saving to the left of the national saving supply curve.supply curve.


When the real domestic interest rate When the real domestic interest rate is low, capital will flow out to foreign is low, capital will flow out to foreign markets where the real interest rate markets where the real interest rate is higher.is higher.

A higher real domestic interest rate A higher real domestic interest rate will cause an inflow of capital because will cause an inflow of capital because foreigners will look for a higher rate foreigners will look for a higher rate of return on their investments.of return on their investments.

investment and saving

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