Lecture 7 INVESTMENT FINANCIAL INTERMEDIATION FINANCIAL MARKETS INVESTMENT

Lecture 7 INVESTMENT, FINANCIAL INTERMEDIATION & FINANCIAL MARKETS

INVESTMENT An action taken today that has costs today but provides benefits in the future. • Firm building plant today incurs costs today but earns revenue in the future • Student incurs costs to attend university now for the sake of higher earnings in the future • Government spends money today to build a dam to have a source of hydroelectric power in the future $$$

NOMINAL INTEREST RATES Interest rates actually charged in the market. REAL INTEREST RATES Nominal interest rates adjusted for inflation.

FINANCIAL INTERMEDIARIES Organizations that receive funds from savers and channel them to investors. • financial institutions such as banks, savings and loans, and insurance companies

ANIMAL SPIRITS John Maynard Keynes emphasized that sharp swings in moods of investors were often irrational and perhaps reflected our most basic, primal instincts.

ACCELERATOR THEORY One theory of investment spending that emphasizes the role of expected growth in real GDP on investment spending. When real GDP growth is expected to be high, firms anticipate that their investments in plant and equipment will be profitable and therefore increase their total investment spending.

PROCYCLICAL Increases during booms and falls during recessions • Investment spending is highly procyclical

INVESTMENT IN STRUCTURES AND EQUIPMENT IN THE EARLY 1990 s Billions of 1990 dollars Billions of 1992 dollars 550 210 200 500 190 450 180 400 170 350 160 89 90 91 92 Year 93 94 95 Non-residential structures 89 90 91 92 93 94 95 Year Producers’ durable Equipment Source: Data from Economic Report of the President, Washington, DC: U. S. Government Printing Office, yearly

MULTIPLIER-ACCELERATOR MODEL • In this model a downturn in real GDP would lead to a sharp fall in investment, which, in turn, would entail further reductions in GDP through the multiplier for investment spending.

BOND A promise to pay money in the future

NOMINAL INTEREST RATES • Interest rates quoted in the market at savings and loans or banks or for bonds • These are actual rates that individuals or firms pay or receive when they borrow money or lend money

REALITY PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value.

REAL RATE OF INTEREST • Nominal rate of interest minus the inflation rate Real rate = Nominal rate - inflation rate

EXPECTED REAL INTEREST RATE The nominal rate minus the expected inflation rate. Country 3 -Month Interest Rate Australia Belgium Canada Denmark France Germany Italy Japan Spain United States 8. 12 5. 13 7. 86 6. 95 7. 80 4. 65 11. 00 1. 36 9. 28 6. 08 Inflation Rate over last 3 months 3. 3 2. 4 4. 2 2. 1 2. 3 3. 9 6. 3 -1. 7 7. 9 3. 3 Expected real rate of interest 4. 82 2. 73 3. 66 4. 85 5. 50 0. 75 4. 70 3. 06 1. 38 2. 78 Source : The Economist, April 29, 1995, pp 122 -23

TYPICAL INVESTMENT 0 Cost -$100

TYPICAL INVESTMENT Return 0 Cost -$100

TYPICAL INVESTMENT $104 Return 0 Cost -$100 A typical investment, in which a cost of $100 incurred today yields a return of $104 next year.

PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it. • Used to help decide whether to undertake investment • If the firm undertakes the investment, it must give up $100 today to get $104 the following year • The interest rate provides a measure of the opportunity cost of the investment

Real Rate of Interest INTEREST RATES AND INVESTMENT Investment Spending As the real interest rate declines, investment spending in the economy increases.

Real Rate of Interest INTEREST RATES AND INVESTMENT Investment Spending As the real interest rate declines, investment spending in the economy increases.

Real Rate of Interest INTEREST RATES AND INVESTMENT Investment Spending As the real interest rate declines, investment spending in the economy increases.

Real Rate of Interest INTEREST RATES AND INVESTMENT Investment Spending As the real interest rate declines, investment spending in the economy increases.

REAL INVESTMENT SPENDING • Inversely related to the real interest rate • Nominal interest rates are not necessarily a good indicator of the true cost of investing • Inflation would increase the nominal rate of return and nominal interest rate equally • A firm makes its investment decisions by comparing its expected real net return from investment projects to the real rate of interest

NEOCLASSICAL THEORY OF INVESTMENT • Pioneered by Dale Jorgenson of Harvard • Real interest rates and taxes play a key role in determining investment spending • Jorgenson used his theory to analyze the responsiveness of investment to a variety of tax incentives, including investment tax credits that are subsidies to investment

Q-THEORY OF INVESTMENT • Originally developed by Nobel laureate, James Tobin of Yale University • Theory states that investment spending increases when stock prices are high • If stock prices are high, it can issue new shares of its stock at an advantageous price and use the proceeds to undertake new investment • Recent research has shown a close connection between Q-theory and neoclassical theory and highlighted the key role that real interest rates and taxes play in the Q-theory as well

SOURCE OF INVESTMENT SPENDING • Investment spending in an economy must ultimately come from savings • When households earn income, they consume part and save the rest • These savings become the source of funds for investment in the economy

LIQUIDITY • Households want savings to be readily accessible in case of emergencies • Funds deposited in a bank account provide a source of liquidity for households, since these funds can be obtained at anytime

SAVERS AND INVESTORS Savers

SAVERS AND INVESTORS Savers who face risk Risk Loss of Liquidity costs of negotiation

SAVERS AND INVESTORS Savers who face risk Risk Demand Loss of Liquidity High Interest costs of negotiation Rates

SAVERS AND INVESTORS Savers who face risk Risk Demand Loss of Liquidity High Interest costs of negotiation Rates from Investors

FINANCIAL INTERMEDIARIES • Institutions such as banks, savings and loans, insurance companies, money market mutual funds, and many other financial institutions • Accept funds from savers and make loans to businesses and individuals • Pool funds of savers, reducing costs of negotiation • Acquire expertise in evaluating and monitoring investments • Some financial intermediaries, such as banks, provide liquidity to households

DIVERSIFICATION • Investing in a large number of projects whose returns, although uncertain, are independent of one another • How financial intermediaries reduce risk

Financial Intermediaries Savers Investors

Financial Intermediaries Savers Financial Intermediary Bank banks savings and loans insurance companies Investors

Financial Intermediaries Savers Financial Intermediary Bank make deposits to banks savings and loans insurance companies Investors

Financial Intermediaries Savers Investors Financial Intermediary Bank make deposits to make loans to banks savings and loans insurance companies

FINANCIAL INTERMEDIATION MALFUNCTIONS • Financial intermediation failures occurred for banks in the USA during the Great Depression and for savings and loans during the savings and loan crises of the 1980 s • During the 1930 s worried depositors and rumors triggered runs on banks • Since banks, as financial intermediaries, never keep 100% of funds on hand, the runs closed down thousands of healthy banks • To prevent this from happening again, the U. S. government began to provide deposit insurance for banks and savings and loans

FINANCIAL INTERMEDIATION MALFUNCTIONS • Deposit insurance indirectly helped create savings and loan crisis during the 1980 s • The government tried to assist the (struggling) saving and loan industry by reducing regulations • Many investment projects collapsed and the government was forced to bail out many savings and loans at a cost of nearly $100 billion to the U. S. economy

Financial Markets • Financial markets are financial institutions through which savers can directly provide funds to borrowers. In financial markets, there is no “middle man”. The two most important financial markets in the economy are bond and stock markets.

Bond Market - 1 • Bonds are nothing more than an IOU. All bonds contain specific information about how much is being borrowed (the principal), when the bond must be repaid (the maturity date), and the rate of interest that must be paid periodically until the bond is repaid.

Bond Market - 2 • Bonds are issued by companies, as well as the federal, state and local governments, to raise money. When a company or government issues a bond, they are borrowing money. When a person buys a bond, and becomes a bondholder, that person is the lender (or creditor).

Bond Market - 3 • Bonds are traded in markets where the interaction of the demand supply for each type of bond determines that bonds price. There are three important characteristics that affect the value of all bonds: – the term (how long until the bond is due? ); – the credit risk (what is the probability that the firm borrowing money will default? ); and – the tax treatment (is the interest paid on the bond taxable by the federal government? ).

Bond Market - 4 • Each of these three characteristics determine the riskiness and profitability of buying and holding a bond, and therefore affect the demand for the bond. As bonds become more risky, the demand for the bond falls, and the bond issuer must offer to pay a higher interest rate to persuade people to purchase the bond.

Bond Market - 5 • As bonds become more profitable, the demand for the bond rises. Because of this, tax free municipal bonds pay low rates of interest.

Stock Markets - 1 • Issuing stock is another way for firms to raise money (the government cannot issue stock). Whoever buys a firm’s stock becomes a part owner of that firm.

Stock Markets - 2 • The money received by a firm from issuing stock never needs to be repaid (so stockholders are NOT creditors). Like bonds, stock prices are determined in markets by the interaction of the demand supply for each individual stock.

Stock Markets - 3 • Stock prices reflect people’s expectations about the firm’s future profitability. When firms are expected to be profitable, demand will be high, and the stock price will rise. When firms are expected to lose money, demand will below, and the stock price will fall.