LECTURE VI. 17 July Tuesday, July 17, 12

Transcription

1 LECTURE VI 17 July 2012

2 BUSINESS CYCLES (CONC)

3 SHOULD WE STABILIZE? Should: Stabilization curbs household and firm pessimism, which leads to deeper recessions and wasted resources Why suffer? Should Not: Monetary policies take a long time to take effect, fiscal policies have to deal with political distortions and lags Being wrong can exacerbate conditions

4 REVIEW Business cycles are short-term divergences from the natural rate of output or long-term growth rate Macroeconomists disagree on how recessions are caused Different schools of thought propose different solutions on how to manage (if we manage) business cycles

5 TOPIC 7 Interest Rates and the Economy

6 BIG PICTURE What are components of the financial markets and what purpose do they serve in the economy? What motivates pricing of financial assets? (Hint: time and risk) How can we combine financial markets and economic investment to model markets for loanable funds for investment?

7 Government Expenditure Consumption Expenditure Taxes Government Households Transfers Income Save Interest Loans Repayment Profits Output Market Economic Investment Factor Market Financial Market Repayment Revenue Firms Costs Loans Exports Imports Rest of the World Repayment Loans

8 BASICS OF FINANCE Financial markets: move money from those that save to those that borrow (here, investment) Economic investment: Payments for new additions to public or private capital stock Financial investment: Buying or building an asset with expectation of financial gain (broader definition) Economic investments can also often be considered financial We are generally interested in economic investments, unless otherwise specified (like the next slide)

9 FINANCIAL MARKETS Two types: Bond Markets: A loan to a company. The bond indicates the quantity and timing of repayment Stock Markets: Piece of ownership in a firm. Returns come through share of profits (dividends) Financial intermediaries are institutions that make transfer of funds easier: banks and mutual funds Bond Purchase Stock Purchase Lenders Save Interest Banks Loan Repayment Borrowers Stock Dividend Bond Return

10 EVALUATING INVESTMENTS

11 SAVINGS: PRESENT VALUE What factors do you consider when saving, spending, or investing? Present Value: Would you rather have $100 today or $ years from now? How about $100 today or $200 5 years from now Need present value: the amount of money needed today given interest rates to produce a given future amount of money Think about the example. If I could invest $100 today and get $300 in 5 years or get $100 today and get $150 in 5 years, the attractiveness changes

12 SAVINGS: PRESENT VALUE Compound interest is the most powerful force in the universe. - Einstein Need to figure out how interest rates affect financial investments Compound interest: interest accrues not only on original money but also on previously received interest Suppose you invest $100 at 10% interest a year: 1. $ *$100=$110 (net +$10) 2. $ *$110=(1+.10)*$110=(1+.10)*(1.10)*$100=$121 (net + $11) So after t years, the investment is worth (1+.10)^t *100

13 SAVINGS: PRESENT VALUE P - initial investment, i - interest rate, Y - final yield, then Y=P*(1+i)^t The present value of Y is then the money we would need to invest today or P=Y/(1+i)^t Back to: How about $100 today or $200 5 years from now with interest rate 5% With interest rate 20%? Exercise: Practice Problems A

14 SAVINGS: PRESENT VALUE P - initial investment, i - interest rate, Y - final yield, then Y=P*(1+i)^t The present value of Y is then the money we would need to invest today or P=Y/(1+i)^t Back to: How about $100 today or $200 5 years from now with interest rate 5%? Present value of $200 is $ so is more valuable With interest rate 20%? Present value of $200 is $80.38 so take the $100; could invest $80.38 and get $200 in 5 years and still consume $19.62 today

15 SAVINGS: RISK Not all returns are certain, think of stocks Recall return on sure investment after 1 period: Return = Investment*(1+i) On a risky investment: Expected Return = Investment*(1+i)*Probability(Event with return (positive) or loss (negative) i) i changes with the events

16 SAVINGS: RISK Suppose we have two types of investments: A: $100 gives a $200 no matter what B: $100 gives a return of $100 with 50% probability and $300 with 50% probability Both have expected returns of $200, but B is riskier We assume people are risk neutral--only care about expected return We could have also assumed people are risk averse, i.e. would rather have a sure thing with a lower expected value than a gamble that might give a better return. Which might be more realistic?

17 SAVINGS: RISK EXAMPLE Ex1: A $100 investment that will default (total loss) with 50% probability or give a 10% return with 50% probability: Y =.5*$100*(1+.1)+.5*$100*0=$55 Ex2: A $100 investment that has 0 return with 50% or 5% with 50% probability Y =.5*$100*(1+0)+.5*$100*(1+.05)=$102.5 Ex3: A $100 investment that defaults with 50% probability or has a 200% return with 50% probability Y =.5*$100*0+.5*$100*(1+2)=$150 Which ones might you invest in?

18 SAVINGS SUMMARY We consider present value and risk when buying investments Higher interest rates lower the present value of future assets Higher interest rates are needed to make risky investments attractive Efficient market hypothesis: Asset prices reflect all publicly available information about the value of an asset, including riskiness and future value Why was this a problem in the financial crisis with collateralized debt obligations?

19 RISK-FREE RATE OF RETURN Short-term US bonds are considered to be risk free. Why? Interest rates on these bonds are risk-free interest rates These bonds still pay a positive return, even though they are risk-free. Why? People still prefer to consume now rather than later It does not take into account compensation for risk Riskier assets might use the risk-free rate as a base line The Federal Reserve can control the risk-free rate, and thus has an ability to influence the price of all assets (more on this next week)

20 DIVERSIFICATION Riskier assets can be appealing because of a higher return (compared to US bonds, for example) Diversification of assets in terms of risk is a way to make your overall portfolio safer. Why? Diversifiable Risk: risk that can be reduced by diversification, i.e. what is bad for Microsoft stock might be good for Apple stock Non-diversifiable Risk / Systemic Risk: Risk that cannot be reduced by diversification (i.e. that caused by a recession since it hurts the value of all assets) Riskier assets typically have lower prices (equivalent to higher returns) to compensate for the risk

21 PRACTICE PROBLEMS Suppose Steve has won the lottery. He can take $500 today or $100 over the next eight years. Which plan should he choose if interest rates are 10%? 20%? Suppose Steve has $500 to spend today. Which should he choose? 1. A 1-year T-bill paying 5% interest 2. Stocks that will return i=-1 with 5% probability, i=.05 with 45% probability, i=.1 with 45% probability, and i=.5 with 5% probability

22 SAVING, INVESTMENT IN NATIONAL ACCOUNTS

23 NATIONAL SAVINGS We will assume until the end of the course we are in a closed economy--there is no international trade Recall that consumer savings are simply income not consumed National savings: total income that remains in the economy after paying for consumption and government expenditures; S=Y-C-G (Y is national income now) For the consumer, savings can be directly used as a pool of money in financial markets available for investment So is this the same relationship at the national level?

24 NATIONAL SAVINGS Consider a closed economy (so NX=0), then Y=C+I+G I=Y-C-G=S so I=S, or total investment is equal to savings like in the consumer case. So the amount of money put into the financial market must equal that taken out Now consider an economy with taxes so the government has money Private savings: Y-C-T (income minus consumption and taxes) Public savings: T-G (taxes are government income minus expenditure) National Savings: S=(Y-C-T)+(T-G) What other sources of savings could there be?

25 LOANABLE FUNDS

26 MARKET FOR LOANABLE FUNDS Market for loanable funds: Market for those that want save (supply) funds and those who want to borrow (demand) funds for investment Recall that savings are the pool of money for investments and hence are supply Standard supply and demand model, but what is the price of a loan?

27 MODELING INVESTMENT The price is interest rate. Consider, the higher the interest rate the more expensive is the loan or the more lucrative is the borrowing Interest Rates Supply Demand Loanable Funds

28 MODELING INVESTMENT What if there is a policy that increase the incentive to save? For example? Interest Rates As supply increases, prices (interest rates) decrease, so more people take out loans What if supply decreases? Supply Demand Loanable Funds

29 MODELING INVESTMENT What if there is a policy that increase the incentive to investment? For example? Interest Rates As demand increases, prices (interest rates) increase, but the credit outweighs the higher cost What if demand decreases? Supply Demand Loanable Funds

30 CROWDING OUT Suppose the government increases spending without more taxes. What happens to savings S decreases because T-G decreases Interest Rates As supply shifts, prices increases and loans decrease so investment decreases. How might this play out during a recession when the government increases spending? Crowding out: A decrease in investment resulting from a decrease in public savings Supply Demand Loanable Funds Let s think about the impact on the larger economy

31 PRACTICE PROBLEM B Consider the following Investment $150 Taxes minus Transfers $200 Consumption? Government $300 GDP $500 What is consumption? What is the level of National Savings? What is the level of Private Savings? What is the level of Public Savings?

32 REVIEW Financial markets move money from those that save to those that want to borrow Financial assets are priced based on timing and expected risk Savings are key to making money available for economic investment In the aggregate economy, we can divide savings into public and private savings