Economics principles tools and applications 9th by sullivan sheffrin perez chapter 12

All Rights Reserved12.1 AN INVESTMENT: A PLUNGE • Accelerator theory The theory of investment that says that current investment spending depends positively on the expected future growth

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Economics

NINTH EDITION

Chapter 12

Investment and Financial Markets

Prepared by Brock Williams

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Learning Objectives

12.1 Explain why investment spending is a volatile component of GDP.

12.2 Discuss the concept of present value.

12.3 Describe the role of interest rates in making investment decisions.

12.4 List the ways that financial intermediation can facilitate investment

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12.1 AN INVESTMENT: A PLUNGE

• Accelerator theory

The theory of investment that says that current investment

spending depends positively on the expected future growth of real GDP

The share of investment as a component of GDP ranged from a low of about 10 percent in 1975 to a high of over 18 percent in

2000

The shaded areas represent U.S recessions

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12.1 AN INVESTMENT: A PLUNGE

• Procyclical

Moving in the same direction as real GDP.

• Multiplier-accelerator model

A model in which a downturn in real GDP leads to a sharp fall in investment, which triggers further reductions in GDP through the multiplier.

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APPLICATION 1

ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING

APPLYING THE CONCEPTS #1: How do fluctuations in energy prices affect investment decisions by firms?

One important way volatility of oil prices can hurt the economy is by creating uncertainty for firms making investment decisions Consider whether a firm should invest in an energy-saving technology for a new plant:

• If energy prices remain high, it may be profitable to invest in energy-saving technology

• If prices fall, these investments would be unwise

• If future oil prices are uncertain, a firm may simply delay building the plant until the path of oil prices are clear

When firms are faced with an increasingly uncertain future, they will delay their investment decisions until the uncertainty is resolved

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12.2 EVALUATING THE FUTURE (1 of 3)

Understanding Present Value

PRESENT VALUE AND INTEREST RATES

• Present value

The maximum amount a person is willing to pay today to receive a payment in the future

PRINCIPLE OF OPPORTUNITY COST

The opportunity cost of something is what you sacrifice to get it.

1. The present value—the value today—of a given payment in the future is the maximum amount a person is willing to pay today for that payment

2. As the interest rate increases, the opportunity cost of your funds also increases, so the present value of a given payment in the future falls In other words, you need less

money today to get to your future “money goal.”

3. As the interest rate decreases, the opportunity cost of your funds also decreases, so the present value of a given payment in the future rises In other words, you need

more money today to get to your money goal.

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APPLICATION 2

THE VALUE OF AN ANNUITY

APPLYING THE CONCEPTS #2: How can understanding the concept of present value help us evaluate an annuity?

• Suppose you and your employer both had set aside funds for the day you retire at age 65 Just before you retire, your employer offers you’re the following options: 1) You

can have the $500,000 that was set aside, or 2) the firm would take the $500,000 and purchase you an annuity contract -a financial instrument that would pay you a fixed

annual payment of $35,000 per year as long as you live

• The first step in making this decision would be to calculate the present value of the annuity payments and compare it to the $500,000 Of course,, you do not know for sure how long you would live, so you would need some estimates of the probability of surviving at each age into the future You would multiply that probability by the yearly annuity payment to obtain an expected annuity payment for every future year Finally, you could need to choose an interest rate and calculate the expected present value of the annuity payments and compare it to the $500,000

• Hopefully, your firm offered you a well-price annuity But the decision is still yours The annuity would be a better deal for you if you were healthier than average and expected to live longer than the average person On the other hand, if you had poor health, it would not be a good idea

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12.2 EVALUATING THE FUTURE (2 of 3)

Real and Nominal Interest Rates

REAL-NOMINAL PRINCIPLE

What matters to people is the real value of money or income—the purchasing power—not the face value of money.

• Nominal interest rate

Interest rates quoted in the market

• Real interest rate

The nominal interest rate minus the interest rate

• Expected real interest rate

•

The nominal interest rate minus the expected inflation rate

•

real rate = nominal rate – inflation rate

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• There are different types of interest investments

• Corporate bonds are considered more risky than federal

government bonds, so pay a higher interest rate

• Long term investments are more risky than short term

investments, so again pay a higher interest rate

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12.3 UNDERSTANDING INVESTMENT DECISIONS (1 of 3)

As the real interest rate declines, investment spending in

the economy increases.

• Neoclassical theory of investment

A theory of investment that says both real interest rates and

taxes are important determinants of investment

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Investment and the Stock Market

• Retained earnings

Corporate earnings that are not paid out as dividends to their owners

• Corporate bond

A bond sold by a corporation to the public in order to borrow money

• Q-theory of investment

The theory of investment that links investment spending to stock prices

price of a stock = present value of expected future dividend payments

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12.3 UNDERSTANDING INVESTMENT DECISIONS (3 of 3)

Both the stock market and investment spending rose

sharply from 1997, peaking in mid-2000.

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12.4 HOW FINANCIAL INTERMEDIARIES

• Liquid

Easily convertible into money on short notice

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• Financial intermediaries

Organizations that receive funds from savers and channel

them to investors

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• Securitization

•

The practice of purchasing loans, re-packaging them, and selling them to the financial markets

• Leverage

•

Using borrowed funds to purchase assets

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APPLICATION 3

UNDERWATER HOMEOWNERS AND DEBT FORGIVENESS?

APPLYING THE CONCEPTS #3: Should we have done more to assist homeowners with burdensome mortgage debt?

•

During the housing boom, many homeowners borrowed money to purchase their property but then saw the value of their homes fall sharply In 2012 approximately 12 million U.S homeowners owed more on their home mortgages than their home was actually worth, this is commonly known as being “underwater.” Should we have tried to help them more?

•

Atif Mian and Amir Sufi provided strong evidence that in the aftermath of the Great Recession, the speed of recovery depended critically on providing assistance to underwater homeowners

•

Households with higher debt burdens reduced spending more than those with lower debt burdens by a factor of almost three to one By not helping those homeowners, consumption spending was substantially reduced

•

Policymakers tried a variety of programs but they proved to be controversial and difficult to administer

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When Financial Intermediaries Malfunction

• Bank run

Panicky investors simultaneously trying to withdraw their funds from a bank they believe may fail

• Deposit insurance

Federal government insurance on deposits in banks and savings and loans

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APPLICATION 4

SECURITIZATION: THE GOOD, THE BAD, AND THE UGLY

APPLYING THE CONCEPTS #4: How have recent financial innovations created new risks for the economy?

• As securitization developed, it allowed financial intermediaries to provide new funds for borrowers to enter the housing market

• As the housing boom began in 2002, lenders and home purchasers began to take increasing risks Lenders made “subprime” loans to borrowers with limited ability

to actually repay their mortgages

• Some households were willing to take on considerable debt because they were confident they could make money in a rising housing market Lenders securitized the subprime loans and financial firms offered exotic investment securities to investors based on these loans Many financial institutions purchased these securities without really knowing what was inside them

• When the housing boom stopped and borrowers stopped making payments on subprime loans, it created panic in the financial market Effectively, through

securitization the damage from the subprime loans spread to the entire financial market, causing a major crisis

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KEY TERMS

Accelerator theory Neoclassical theory of investment

Bank run Nominal interest rate

Corporate bond Present value

Deposit insurance Procyclical

Expected real interest rate Q-theory of investment

Financial intermediaries Real interest rate

Leverage Retained earnings

Liquid Securitization

Multiplier-accelerator model

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