Professor Christina Romer. LECTURE 18 SAVING AND INVESTMENT IN THE LONG RUN March 22, 2017

Transcription

1 Economics 2 Spring 2017 Professor Christina Romer Professor David Romer LECTURE 18 SAVING AND INVESTMENT IN THE LONG RUN March 22, 2017 I. OVERVIEW II. REVIEW OF THE INVESTMENT DEMAND CURVE III. SAVING AND INVESTMENT A. The uses of Y* B. Equilibrium C. Decomposing national saving into private and public saving IV. NATIONAL SAVING AND THE REAL INTEREST RATE A. Utility maximization B. The supply of saving curve C. Example: A tax cut V. THE DETERMINANTS OF INVESTMENT AND THE REAL INTEREST RATE IN THE LONG RUN A. Equilibrium r* and I* B. Example: A tax cut revisited C. Example: A new technology that raises future MRPK s VI. STOCK PRICES A. Financial capital versus physical capital B. Stock price equals the PV of expected future dividends C. What affects stock prices? D. Efficient markets hypothesis E. Three kinds of risk

2 Economics 2 Spring 2016 Christina Romer David Romer LECTURE 20 Saving and Investment in the Long Run April 5, 2016

3 Midterm 2 Reminders Thursday, March 23 rd, 3:40 5:00. You do not need a blue book. If your GSI is Nick Sander (Sections 101 & 107), go to 166 Barrows; if your GSI is Pablo Muñoz (Sections 109 & 110) or Todd Messer (Sections 102 & 114), go to 50 Birge. DSP students: You should have received an from the course assistant (Gillian Brunet gbrunet@berkeley.edu) about arrangements. Everyone else come to usual room (155 Dwinelle).

4 I. OVERVIEW

5 Aggregate Production Function (1) (2) (3)

6 Where We re Headed: The Long-Run Saving and Investment Diagram r* S r 1 I 1 I S*, I* Here S is saving, I is investment, and r is the real interest rate (and * denotes a long-run value).

7 II. REVIEW OF THE INVESTMENT DEMAND CURVE

8 The Condition for Profit Maximization Capital is an input into production, so one might think profit-maximization implies that a firm will buy new capital goods (that is, invest) to the point where MRP K = Purchase Price of Capital Goods. But: The purchases price is paid immediately, and a capital good has a marginal revenue product for many years in the future. Thus, the condition for profit-maximization is: PV(Stream of MRP K s) = Purchase Price Aside: If we want to be precise, it s really expectations of the stream of MRP K s, not the actual MRP K s.

9 Present value of a stream of payments that s different in different years: PV(Stream of F s) = F 1 F 2 F 3 F t (1 + i) 1 (1 + i) 2 (1 + i) 3 (1 + i) t F n = future payment in year n i = interest rate (expressed as a decimal) t = number of years in the future the last payment is made

10 The Real Interest Rate (r) The real interest rate is the nominal (conventional) interest rate adjusted for inflation: r i π, where: i = nominal interest rate π = inflation rate We can rearrange this as: i r + π Aside: If we want to be precise, the relevant inflation variable is in fact the expected rate of inflation, not the actual rate of inflation.

11 Investment Demand and the Real Interest Rate For simplicity, think of a competitive firm, so MR = P. So: MRP K = MP K P. If there is inflation, P will be rising over time.

12 Investment Demand and the Real Interest Rate (continued) For a competitive firm, PV(Stream of Future MRP K s) MP K P 1 MP K P 2 MP K P 3 MP K P t = (1 + i) 1 (1 + i) 2 (1 + i) 3 (1 + i) t Recall that i = r + π. If i rises only because π rises, PV won t change because the P s will also rise. But if i rises because r rises, PV falls. Thus: Investment demand is a decreasing function of the real interest rate.

13 Investment Demand Curve Real Interest Rate (r) I Investment (I)

14 III. SAVING AND INVESTMENT

15 Where We re Headed: The Long-Run Saving and Investment Diagram r* S r 1 I 1 I S*, I* Here S is saving, I is investment, and r is the real interest rate (and * denotes a long-run value).

16 The Relationship between Normal Investment and the Normal Real Interest Rate Normal Real Interest Rate (r*) I Normal Investment (I*)

17 The Uses of Potential Output

18 Equilibrium Condition

19 Private and Public Saving

20 IV. NATIONAL SAVING AND THE REAL INTEREST RATE

21 The Supply of Saving Recall: Normal national saving (S*) = Y* C* G*. Y* is determined by K*/N*, technology, and N*/POP. We take G* as given. So: To understand what determines S*, we need to understand what determines C*.

22 Utility Maximization between the Present and the Future What is the opportunity cost of 1 unit of current consumption in terms of future consumption? If I consume 1 unit less of goods and services today:

23 Utility Maximization between the Present and the Future (continued) MU current P current = MU future P future

24 The Supply of Saving r* Saving (S*) Recall: S* = Y* C* G*

25 Example: A Tax Cut r* S 1 Saving (S*) Recall: S* = Y* C* G*

26 A Note on How We Model the Government

27 Private and Public Saving and a Tax Cut S* = (Y* T* C*) + (T* G*) Private Saving Public Saving Suppose there is a tax cut. At a given r:

28 V. THE DETERMINANTS OF INVESTMENT AND THE REAL INTEREST RATE IN THE LONG RUN

29 The Long-Run Saving and Investment Diagram r* S*, I*

30 A Tax Cut and Crowding Out r* S 1 r 1 I 1 I 1 S*, I*

31 A New Technology That Raises Future MRP K s r* S 1 r 1 I 1 I 1 S*, I*

32 VI. STOCK PRICES

33 Physical Capital versus Financial Capital Physical capital refers to man-made aids to the production process: machines, buildings, trucks, computers. Financial capital refers to the funds used to purchase, rent or build physical capital.

34 Two Ways to Raise Financial Capital Issue bonds: borrow funds in return for a promise to repay later with interest. Issue stocks: sell people a share of the company. In return, they are entitled to a share of future profits (that is what a dividend is).

35 What should someone be willing to pay for a stock? Stock price = PV(Stream of Expected Future Dividends)

36 What moves stock prices? A change in the interest rate. Lower interest rates, all else equal, are likely to be associated with higher stock prices. A change in expected future dividends. If something makes people expect higher future dividends, that should be associated with a higher stock price. The higher expected dividends could apply to a particular firm or to firms in general.

37 Bristol Myers Squibb Stock Price and Drug Approval Source: Barron s and CNN Money.

38 Chipotle Stock Price and News about Illness News of salmonella and e. coli: October 2015 Source: CNN Money

39 S&P 500 and News about the Financial Crisis S&P 500 (Index) Lehman Bankruptcy Vote against TARP Source: FRED, Federal Reserve Bank of St. Louis.

40 Recent Overall Stock Price Movements Source: FRED.

41 Efficient Markets Hypothesis It is difficult to make money off news in the stock market because information is processed very quickly.

42 Three Types of Risk Idiosyncratic (or diversifiable) risk: Risk that is unrelated to the overall behavior of the economy. Systematic (or nondiversifiable) risk: Risk that is correlated with the overall behavior of the economy. Asymmetric-information risk: Risk arising from one party having information that the other doesn t. Asymmetric-information risk may be affected by the nature of the contract.