Investment & Saving

Outline

•Physical versus financial capital

•Financial markets

•Theory of investment

•Investment demand

•The supply of savings

•Financial market equilibrium

•Effect of government saving

•The “crowding out” effect

–Physical capital–The tools, instruments, machines, buildings, and other constructions that have been produced in the past and that are used to produce goods and services.

–Financial capital–The funds that firms use to buy and operate physical capital.

• Capital and Investment–Gross investment–The total amount spent on new capital goods.

–Net investment–The change in the quantity of capital—equals gross investment minus depreciation.

Gross v. Net Investment: Again

Stock Markets

• Stock (Equity): A certificate of ownership and claim to the profits of a corporation.

• Stock Market: An institution that facilitates the transfer of stocks among wealth holders.

Examples: NYSE, NASDAQ, London Stock Exchange, Paris Bourse, Tokyo Stock Exchange, Toronto Stock Exchange

Bond Markets

Bond–A promise to pay specified sums of money on specified dates; it is a debt for the issuer.–Bond market–A financial market in which bonds issued by firms and governments are traded.

Firms issue new stocks or bonds to raise the financial

capital necessary to purchase new capital goods.

Theory of Investment

Why do firms purchase things like new offshore drilling

platforms, food processing plants, or bulldozers? Because they expect they can

make a profit by doing so.

Investment Function

),( rfI Let

Where:

•I is gross investment

is the expected profit of investment; and

•r is the interest rate.

The Investment Decision

Acquisition cost of a tractor–trailer rig . . . . . . . . $146,000.00

Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 years

Expected (extra) sales revenue per yearfrom the use of the asset . . . . . . . . . . . . . . . . . . $149,000.00

Expected costs per year to operate the asset . . $129,000.00

Diesel fuel $37,000 Driver salary & benefits 68,000 Repairs (including tires) 19,000 Misc. (fees, fines, etc.) 5,000

Expected net sales revenue per year from the use of the asset . . . . . . . . . . . . . . . . . . $20,000.00

Computing expected profit ()

100Good Capital theofCost n Acquisitio

YearPer Revenue SalesNet Expected

To compute expected profit in percentage terms:

Thus we have:

%7.13100000,146$

000,20$

We would consider the tractor-trailer rig a sound investment if the interest rate

were less than 13.7 percent.

– Investment demand– The relationship between the quantity of

investment demanded and the interest rate, other things remaining the same.

– Investment demand is shown by an investment demand schedule or and investment demand curve.

– As the interest rate decreases, more investment projects become attractive in the assessment of business decision-makers—hence, the investment demand function is downward-sloping with respect to the interest rate.

•Objective influences such as the phase of the business cycle, technological change, and population growth

•Subjective influences summarized in the phrase “animal spirits”

What factors could cause the investment demand function to shift?

1. To have a more secure future, to start a business, to finance a child’s education, to satisfy miserliness, . . .

2. To earn interest. We view interest as

the “reward for saving” or the “reward for postponing

gratification.”

Interest rate Future value4% $1,127.275% $1,161.476% $1,196.687% $1,232.938% $1,270.249% $1,308.6510% $1,348.1811% $1,388.8812% $1,430.77

Value of $1,000 in 3 years at alternative interest rates

The opportunity cost of spending

now (measured in lost future

spending) is positively related to

the interest rate.

• Government Budget and Government Saving

GDP is the sum of consumption expenditure, C; investment, I; government purchases, G; and net exports, NX.

In the global economy, net exports are zero, so for the world as a whole:

Y = C + I + G

GOVERNMENT IN THE FINANCIAL MARKET

–GDP equals total income, which is the sum of consumption expenditure, saving, S, and net taxes, NT. So:

Y = C + S + NT–By combining these two ways of looking at GDP, you can see that:

C + I + G = C + S + NT

–Because consumption is on both sides of this equation, we can subtract C and simplify the equation to:

I + G = S + NT–Now subtract government purchases from both sides of this equation to obtain:

I = S + (NT – G)–This equation tells us that investment is financed by private saving and government saving, NT – G. –Government saving, NT – G, is also the government budget surplus.

–Total saving equals private saving plus government saving. –So when the government has a budget surplus, it contributes toward financing investment. –But when the government has a budget deficit, it competes with businesses for private saving and decreases the amount available for investment.

GOVERNMENT IN THE FINANCIAL MARKET

• Effect of Government Saving–A government budget surplus increases total saving supply. –To find total saving supply, we must add the government budget surplus to private saving supply. –An increase in saving supply brings a lower interest rate, which decreases the quantity of private saving supplied and increases the quantity of investment.