Investment and Saving
20 c h a p t e r
In the last chapter on economic growth, we learned that the quantity of capital increases because of saving and investment. That is, the market for saving and investment determines the rate of growth in the quantity of capital. But how do households, businesses, and government determine their levels of investment and saving? What role do financial markets play in determining the quantity of capital and the real interest rate?
FINANCIAL MARKETS
Financial markets facilitate the interaction between households, firms, governments, banks, and other financial institutions that borrow and lend funds. In financial markets, households are the suppliers of funds and firms are the demanders. Government is a demander when it is running a budget deficit and a supplier when it is running a budget surplus. Banks and other financial institutions coordinate the plans of lenders (households) and borrowers (firms). The interest rate is determined in the financial markets.
Financial markets are global. For example, if the real interest rate is higher in England than in the United States, funds will move toward England, providing the risk factor is comparable. Lenders want to receive the highest possible real interest rate, and borrowers want to pay the lowest possible rate. The two most important financial markets are the stock market and the bond market.
STOCKS
The owners of corporations own shares of stock in the company and are called stockholders. Each stockholder's ownership of the corporation and voting rights in the selection of corporate management is proportional to the number of shares owned. Suppose a corporation has 1,000 shares of stock outstanding. If you own 10 shares, you own 1 percent of the corporation (10 is 1 percent of 1,000). Another stockholder who purchases only one share owns one-tenth as much of the corporation as you do. Therefore, she earns one-tenth the dividend income from the stock that you do and has one-tenth the number of votes that you do in annual stockholder meetings to select members of the board of directors. (The board provides overall supervision of the business and hires the management.)
Individuals and institutions buy shares of stock in the stock market, usually on one of the organized stock exchanges. The price of shares will fluctuate (often many times a day) with changes in demand and/or supply. Corporations sometimes use proceeds from new sales of stock to finance expansion of their activities.
There are actually two primary types of stock: preferred stock and common stock. Owners of preferred stock receive a regular, fixed dividend payment; the payment remains the same regardless of the profits of the corporation. No dividends can generally be paid to holders of common stock until the preferred stockholders receive a specified fixed amount per share of stock, assuming that funds are available after the debts of the corporation are paid.
Owners of common stock share in all profits remaining
after expenses are paid, including interest payments to owners of debt obligations of the corporation and dividend payments to owners of preferred stock. Dividends in common stock frequently vary with profits, often going up in years of prosperity and down in less prosperous years. If the corporation is sold or liquidated, the common stockholders receive all the corporate assets after all debts are paid and preferred stockholders are paid a fixed amount per share. Compared with preferred stockholders, owners of common stock assume greater risks because the potential rewards are greater if the company is successful.
WHO OWNS STOCK IN U.S. CORPORATIONS?
Individuals as well as institutions such as insurance companies, pension funds, mutual funds, trust departments of banks, and university and foundation endowment funds hold corporate stocks. To provide a perspective on the ease with which one can share in the ownership of a company, General Mo-
420 CHAPTER TWENTY | Investment and Saving
Financial Markets
s e c t i o n
20.1
_ What are stocks? _ What are bonds?
tors, IBM, and Microsoft have millions of individual stockholders. Indirectly, millions more are involved in stocks through their mutual funds, ownership of life insurance, vested rights in private pension funds, and so on.
BONDS
While a firm's borrowing takes different forms (such as issuing stock or borrowing from a bank), corporations primarily borrow by issuing bonds.
The holder of a bond is not a part owner of the firm; rather, he is a creditor to whom the firm has a debt obligation. The obligation to bondholders is of higher legal priority than that of stockholders. Before the firm can pay any dividends, even to owners of preferred stock, it must meet the interest obligations to bondholders. If a firm is liquidated, bondholders must be paid the full face value of their bond holding before any disbursements can be made to stockholders. Bondholders have greater financial security than do stockholders but receive fixed annual interest payments, with no possibility to receive increased payments as the company prospers.
As a result, the bondholder is less likely to see a substantial increase in the value of his investment —a capital gain—than are stockholders.
THE STOCK MARKET
The two most important financial markets where savers can provide funds to borrowers are the stock market and the bond market. The values of securities
(stocks and bonds) sold in financial markets change with expectations of benefits and costs. For example, if people expect corporate earnings to rise, prospective stockholders increase what they would be willing to pay for the fixed amount of securities and existing stockholders become more reluctant to sell, leading to increased prices. If present business conditions and/or expectations about future profits worsen, stock prices fall. A variety of other concerns, such as the economic policies of the government, business conditions in foreign countries, and concern over inflation also influence the price of stocks (and, to a lesser extent, bonds).
During periods of rising securities markets, optimism is generally great, and businesses are more likely to invest in new capital equipment, perhaps financing it by selling new shares of stock at current high prices.
During periods of pessimism, stock prices fall, and businesses reduce expenditures on new capital equipment, partly because financing such equipment by stock sales is more costly. More shares have to be sold to get a given amount of cash, diluting the ownership interest of existing stockholders.
Can You Consistently Pick Stock Winners?
Economists have a theory about the stock market.
They call it a random walk. That is, it is very difficult, without illegal inside information or a lot of luck, to consistently pick winners in the stock market.
Not too long ago, a chimpanzee in Sweden beat that country's top analyst by throwing darts at a newspaper that included all the listings on the Swedish Stock Exchange. The fact remains that hot tips are only hot if you are one of only a few to know if a company's stock is going to rise. Once that news hits the street, it will cease to be a source of profit. In sum, if markets are operating efficiently, the current stock prices will reflect all available information, and consistent, extraordinary profit opportunities will not exist. Many financial analysts think that the best stock market strategy is to diversify, buying several different stocks and holding them for long periods. At least that way
Financial Markets 421
By Dwight Lee and Richard McKenzie
Did you know that buying a tall drip instead of a latte every morning saves about $1 a day? If you put that money in a mutual fund for 10 years starting at age 22, you could have $90,000 more at retirement.
Try not to gamble away your future. Did you know that, statistically speaking, you are much more likely to be struck by lightning than to win the state lotto?
Stay healthy. A 22-year-old who exercises an hour a day could be worth an additional $250,000 at retirement, thanks to lower medical bills and a longer career.
Did you know that if you were just out of college and bought a used Honda instead of an Audi TT, then took the $25,000 you saved and invested it at 8 percent, you would have an extra $800,000 at retirement?
SOURCE: Dwight Lee and Richard McKenzie, “Getting Rich in America,”
USA Weekend Magazine, August 15, 1999.
CHOICES, COSTS, AND PERSONAL FINANCE
In The NEWS
CONSIDER THIS:
Life is about tough choices and their opportunity costs.
you don't have to continue to pay commissions on additional trades. Besides, over the long run, the stock market has historically outperformed other financial assets.
READING STOCK TABLES
Most newspapers (and many Web sites) have financial sections that cover the prices of stocks so investors can have some of the information they need to make their decisions to buy and sell stocks. Some investors (day traders) watch this data by the second because they trade in and out of stocks many times in one day. At the other extreme, some investors pick a good company and hold the stock for a long time hoping that it will give them a better return than other assets—like saving accounts. Exhibit 1 is a reproduction of the Wall Street Journal
on May 30, 2003. Let's look at the key indicators for one stock—Coca-Cola.
The first column shows the stock price percentage change in the calendar year to date. Columns two and three show the stock's performance over the last 52 weeks—the highest price in the second column and the lowest price in the third column.
We see that Coca-Cola has been as high as $57.50 per share and as low as $37.01.
In column four we see the name of the stock, Coca-Cola, followed by the symbol for Coca-Cola, KO. In column five is the dividend—the annual amount the company has paid over the preceding year on each share of stock. Coca-Cola paid $0.88 per share. If we divide the dividend by the price of the stock, we get the figure in the sixth column called the yield—2.0 percent.
The seventh column has the price-earnings (PE) ratio, found by taking the price of the stock and dividing it by the amount the company earned per share over the past year. The price-earnings ratio is a measure of how highly a stock is valued. A typical price-earnings ratio is around 15. If the PE ratio is higher, it means that the stock is relatively expensive in terms of its recent earnings; the stock might be overvalued, or investors expect share prices to rise in the future. A lower PE ratio means that the stock is either undervalued or that investors expect future earnings to fall.
The last three columns measure the performance of the stock on the last trading day—how many shares changed hands, the closing price, and the net change from the closing price of the previous day.
422 CHAPTER TWENTY | Investment and Saving
Reading a Stock Table SECTION 20.1
EXHIBIT 1
YTD %CHG 52-WEEK HI - LO STOCK (SYM) YLD DIV % PE VOL 100s CLOSE NET CHG
1.8 23.0 -12.0 -31.8 -32.7 27.3 12.8 57.50 26.60 24.50 2.50 19.03 36.05 59.31 37.01 16.22 16.87 1.10 7.65 24.50 44.05 CocaCola KO CC Fensa ADS KOF CocaColaEnt CCE Coeur dAMn CDE ColeNtl A CNJ ColesMyer ADS CM ColgatePalm CL .88 .42e .16 1.22e .96f 2.0 1.9 .8 ...
...
3.4 1.6 27 ...
17 dd ...
...
26 72081 1348 26492 10383 63 6 20622 44.62 22.01 19.12 1.31 7.67 35.65 59.14 0.46 0.01 0.51 0.02 -0.11 -0.40 -0.21
SOURCE: Wall Street Journal, May 27, 2003
© 1997 United Features Syndicate/Universal PressSyndicate
Financial Markets 423
Misinterpreting random sequences is common in sports and investing.
In both arenas, the statistical facts collide with commonsense intuition.
Every basketball player and every fan intuitively “know” that players have hot and cold streaks. When [psychologists] Thomas Gilovich, Robert Vallone, and the late Amos Tversky interviewed members of the Philadelphia 76ers, the players estimated they were about 25 percent more likely to make a shot after they had just made one than after a miss. In one survey, 9 in 10 basketball fans agreed that a player “has a better chance of making a shot after having just made his last two or three shots than he does after having missed his last two or three shots.” Believing in shooting streaks, players will feed the ball to a teammate who has just made two or three shots in a row.
The only trouble is (believe it or not), it isn't true! When Gilovich and his collaborators studied detailed individual shooting records, they found that the 76ers—and the Boston Celtics, the New Jersey Nets, the New York Knicks, and Cornell University's men's and women's basketball players—were equally likely to score after a miss and after a basket. A typical 50 percent shooter averages 50 percent after just missing three shots and 50 percent after just making three shots. It works with free throws, too. Celtics star Larry Bird made 88 percent of his free throws after making a free throw and 91 percent after missing.
Why, then, do players and fans alike believe that players are more likely to score after scoring and to miss after missing?
It's because streaks do occur, more than people expect in random sequences. In any series of 20 shots by a 50 percent shooter (or 20 flips of a coin), there is a 50-50 chance of four baskets (or heads) in a row, and it is quite possible that one person out of five will have a streak of five or six. Players and fans notice these random streaks and so form the errant conclusion that “when you're hot, you're hot” (see Exhibit 2).
The same misinterpretation of random sequences occurs when investors believe that a mutual fund that has had a string of good years will likely outperform one that has had a string of bad years. Based on that assumption, investment magazines report mutual funds' performance. But, as economist Burton Malkiel documents, past performances of mutual funds do not predict their future performance. If on January 1 of each year since 1980 we had bought the previous year's top-performing funds, our hot funds would not have beaten the next year's market average. Putting our money instead on the Forbes “Honor Roll” of funds each year would have gotten us an annual return over nearly two decades since 1975 of 13.5 percent (compared with the market's overall 14.9 percent annual return). Of the top 31 Canadian funds during 1994, 40 performed above average and 41 below average during 1995.
“Randomness is a difficult notion for people to accept,” notes Malkiel. “When events come in clusters and streaks, people look for explanations and patterns. They refuse to believe that such patterns—which frequently occur in random data— could equally well be derived from tossing a coin.”
The point to remember: When watching basketball, choosing stocks, or flipping coins, remember that our intuition often misleads us. Random sequences frequently don't look random.
Expect streaks.
SOURCE: David Myers, Psychology, 6th ed. (New York: Worth Publishers, 2001), p. 30.
HOT AND COLD STREAKS IN BASKETBALL AND THE STOCK MARKET
In The NEWS
Who Is on Fire? SECTION 20.1
EXHIBIT 2
Here are 21 consecutive shots, each scoring either a basket or a miss, by two players who each make 11 baskets. Within this sample of shots, which player's sequence looks more like what we would expect in a random sequence?
Player 1 Player 2
424 CHAPTER TWENTY | Investment and Saving
1. Corporate ownership and voting rights are dispersed among stockholders and are based on the proportion of shares owned.
2. Stock shares are bought and sold in an organized exchange—a stock market—with fluctuations in prices based on supply and demand.
3. Two different types of stock can be issued: preferred stocks and common stock.
4. Stockholders can consist of millions of individuals and institutions that hold an ownership stake in a corporation.
5. Bonds are a financial instrument used by corporations to raise money by promising to repay the amount borrowed and pay the holder fixed annual interest payments.
6. The expectation of future profits, as well as government economic policies, foreign market conditions, and inflation concerns influence the price of securities.
7. Investors obtain information about stocks from published stock tables that help them make purchasing and selling decisions.
8. Price tracking, dividends, and price-earnings ratio figures provide investors with indicators of the value of stock.
1. In financial markets, who are the primary suppliers and who are the primary demanders?
2. Why are financial markets appropriately considered to be global in scope?
3. Who has more voting rights in determining a corporation's policy—an owner of 1% of the common stock or an owner of 10% of the corporation's bands? Who is a larger owner of the corporation?
4. If you believed a company's profitability was about to jump sharply, would you rather own bonds, preferred stock, or common stock in that company?
5. If almost all investors expected the profits of a company to jump sharply, would that make purchasing the stock today unusually profitable?
6. Why are issues of new stocks to finance business investments more common in periods of high and rising stock prices?
7. What are some of the reasons that stock prices rise and fall?
8. What is the random walk?
9. What is a dividend?
10. How do you calculate a price-earnings ratio?
s e c t i o n c h e c k
http://sextonxtra.swlearning.com
To work more with this Chapter's concepts, log on to Sexton Xtra! now.
A brutal six months led to the worst showing for investment professionals in the 10-year history of the column's stock picking contest—an average loss of 53 percent. The best of the four pro picks dropped 22 percent between July 11 and December 29, 2000. The worst plunged an eye-popping 90 percent.
Wall Street Journal readers didn't do much better. The four readers, whose picks were selected at random from among e-mail submissions to WSJ.com, posted an average 43 percent drop. However, a portfolio of stocks chosen by flinging darts at the stock tables did the best, falling only 11percent.
SOURCE: The Wall Street Journal, January 11, 2001, page C1.
EXPERTS, DARTS, READERS TAKE A DRUBBING
In The NEWS
If we put the investment demand for the whole economy and national savings together, we can establish the real interest rate in the investment and saving market. We begin by revisiting investment, and then follow with the introduction of the saving supply (SS) curve and equilibrium.
Exhibit 1 shows the investment demand (ID) curve for all the firms in the whole economy. The investment demand curve is downward sloping, reflecting the fact that investment spending varies inversely with the real interest rate—the amount borrowers pay for their loans. At a high real interest rate, firms will only pursue those few investment activities that have even higher expected rates of return.
As the real interest rate falls, additional projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises. In other words, the investment demand curve shows the dollar amount of investment forthcoming at different real interest rates. Because lower interest rates stimulate the quantity of investment demanded, governments often try to combat recessions by lowering interest rates.
SHIFTING THE INVESTMENT DEMAND CURVE
Several other determinants will shift the investment demand curve. If firms expect higher rates of return on their investments for a given interest rate, the ID
curve will shift to the right, as seen in Exhibit 2. If firms expect lower rates of return on their investments for a given interest rate, the ID curve will shift to the left, also seen in Exhibit 2. Possible investment demand curve shifters include changes in technology, inventory, expectations, or business taxes.
Investment Demand and Saving Supply 425
Investment Demand and Saving Supply
s e c t i o n
20.2
_ What is the investment demand curve?
_ What is the saving supply curve?
_ How is the real interest rate determined?
0 r1
r3
r2
Q2 Q1 Q3
Real Interest Rate, r (expected rate of return)
ID
Quantity of Investment (billions of dollars)
A C B
A B An increase in the real interest rate will lower the quantity of investment demanded.
A C A decrease in the real interest rate will raise the quantity of investment demanded.
The Investment Demand Curve
SECTION 20.2
EXHIBIT 1
There is an inverse relationship between the real interest rate and the quantity of investment demanded. At a higher real interest rate, firms will only pursue investment activities that have the highest expected return, and the quantity of investment demanded falls—a movement from point A to point B. As the real interest rate falls, projects with lower expected returns become potentially profitable for firms, and the quantity of investment demanded rises—a movement from point A to point C.
0 Q3
ID1 ID2
Q1 Q2
Real Interest Rate, r (expected rate of return) Quantity of Investment (billions of dollars)
A B C
A B An increase in the expected profit rate A C A decrease in the expected profit rate
ID3
r1
Shifts in the Investment Demand Curve
SECTION 20.2
EXHIBIT 2
Investment demand depends on the expected rates of return.
For example, a higher expected profit rate causes an increase in investment demand, shifting the ID curve to the right from point A to point B. A lower expected profit rate causes a decrease in investment demand, shifting the ID curve to the left from point A to point C. Any change in technology, inventory, expectations, or business taxes can cause the investment demand curve to shift.
Technology
Product and process innovation can cause the ID
curve to shift rightward. For example, the development of new machines that can improve the quality and the quantity of products or lower the costs of production will increase the rate of return on investment, independent of the interest rate. The same is true for new products like handheld computers, the Internet, genetic applications in medicine, or HDTV. Imagine how many different firms increased their investment demand during the computer revolution.
Inventories
When inventories are high and goods are stockpiled in warehouses all over the country, there is a lower expected rate of return on new investment—the ID
curve shifts to the left. Firms with excess inventories of finished goods have very little incentive to invest in new capital. Alternatively, if inventories become depleted below the levels desired by firms, the expected rate of return on new investment increases as firms look to replenish their shelves to meet the growing demand—the ID curve shifts to the right.
Expectations
If higher expected sales and a higher profit rate are forecasted, firms increase investment in plant and equipment, and the ID curve shifts to the right— more investment will be desired at a given interest rate. If lower expected sales and a lower profit rate are forecasted, the ID curve shifts to the left—fewer investments are desired at a given interest rate.
Business Taxes
If business taxes are lowered—such as with an investment tax credit—potential after-tax profits on investment projects increase and shift the ID curve to the right. Higher business taxes lead to lower potential after-tax profits on investment projects and shift the ID curve to the left.
The Supply of National Saving
The supply of national saving comprises both private saving and public saving. Households, firms, and the government can supply savings. The saving supply (SS) curve is upward sloping, as seen in Exhibit 3. At a higher real interest rate, there is a greater quantity of savings supplied. Think of the interest rate as the reward for saving and supplying funds to financial markets. At a lower real interest rate, a lower quantity of savings is supplied.
As with the investment demand curve, there are noninterest determinants of the saving supply curve. For example, if disposable (after-tax) income were to rise, the supply of savings would shift to the right—more savings would occur at any given interest rate. If disposable income fell, there would be less saving at any given interest rate. Also, if you expected lower future earnings, you would tend to save more now at any given interest rate—shifting the saving supply curve to the right. If you expected higher future earnings, you would tend to consume more and save less now, knowing that more income is right around the corner—shifting the saving supply curve to the left. In Exhibit 4, we see that an increase in disposable income or lower expected future earnings shifts the saving supply curve to the right. A decrease in disposable income or higher expected future earnings shifts the saving supply curve to the left.
In equilibrium, desired investment equals desired national saving at the intersection of the investment demand curve and the saving supply curve. The equilibrium real interest rate is shown by the intersection of these two curves, as seen in Exhibit 5. If the real interest rate, r1, is above the equilibrium real interest rate, r*, forces within the
426 CHAPTER TWENTY | Investment and Saving
0
r1
r3
r2
Q3 Q1 Q2
Real Interest Rate, rSS
A C B
A B An increase in the real interest rate increases saving.
A C A decrease in the real interest rate decreases saving.
Quantity of Saving (billions of dollars)
Saving Supply (SS) Curve
SECTION 20.2
EXHIBIT 3
There is a positive relationship between the real interest rate and the quantity of saving supplied. At a higher real interest rate, there is a greater quantity of saving supplied—the movement from point A to point B. At a lower real interest rate, there is a lower quantity of saving supplied—the movement from point A to point C.
economy would tend to restore the equilibrium. At a real interest rate that is higher than the real equilibrium interest rate, the quantity of saving supplied would be greater than the quantity of investment demanded—there would be a surplus of saving at this real interest rate. As savers (lenders) compete against each other to attract investment demanders (borrowers), the real interest rate falls. Alternatively, if the real interest rate, r2, is below the equilibrium real interest rate, r*, the quantity of investment demanded is greater than the quantity of saving supplied at that interest rate—a shortage of saving occurs. As investment demanders (borrowers) compete against each other for the available saving, the real interest rate is bid up to r*.
CALCULATING PRESENT VALUE
One of the most important decisions a firm makes is investment in new capital. A lot of money will be invested in factory equipment and machines expected to last for many years. The firm making the investment decision must consider the price that it must pay now for the new capital compared with the additional revenue the capital should generate
over time. That is, the firm must compare current costs with future benefits. To figure out how much those future benefits are worth today, economists use a concept called present value.
How Do We Determine the Present Value?
One of the most useful formulas in economics is the formula for present value. The present value of future income is the value of having that future income now. That is, a dollar today is worth more than a dollar in the future. People prefer to have money now rather than later, which is why they are willing to pay interest to borrow it. The present value of receiving $1,000 a year from now can be calculated by using the present-value equation:
PV 5 $X/(1 1 r)t
where X 5 $1,000; r 5 current market interest rate; and t 5 years from now. So the present value
Investment Demand and Saving Supply 427
0 Q3
r1
SS1 SS2
Q1 Q2
Real Interest Rate, r Quantity of Saving (billions of dollars)
A B C
A B An increase in saving supply A C A decrease in saving supply
SS3
Shifts in the Saving Supply Curve
SECTION 20.2
EXHIBIT 4
Any change in determinants of saving supply other than interest rates, like disposable (after-tax) income or expected future earnings, can cause the saving supply curve to shift. An increase in disposable income or lower expected future earnings shifts the saving supply curve to the right, from point A to point B. A decrease in disposable income and higher expected future earnings shifts the saving supply curve to the left, from point A to point C.
r1
r* r2
SS ID
Surplus of Saving (real interest rate falls) Shortage of Saving (real interest rate rises)
Real Interest Rate, r Quantity of Saving and Investment
Equilibrium in the Saving and Investment Market
SECTION 20.2
EXHIBIT 5
Desired investment equals desired national saving at the intersection of the investment demand curve and the saving supply curve, the equilibrium in the saving and investment market.
The intersection of these two curves shows the equilibrium real interest rate. At a higher-than-equilibrium real interest rate, the quantity of saving supplied would be greater than the quantity of investment demanded; there would be a surplus of saving at this real interest rate. As savers (lenders) compete against each other to attract investment demanders (borrowers), the real interest rate falls. If the real interest rate, r2, is below the equilibrium real interest rate, r*, the quantity of investment demanded is greater than the quantity of saving supplied at that interest rate, and a shortage of saving occurs. As investment demanders (borrowers) compete against each other for the available saving, the real interest rate is bid up to r*.
of $1,000 one year from now at the current market interest rate of 5 percent is $1,000/(1.05)1 5 $952.38.
The present value of $1,000 two years from now at a current market interest rate of 5 percent is $1,000/(1.05)2 5 $907.03.
428 CHAPTER TWENTY | Investment and Saving
Year 3% 6% 8% 10% 15% Year
1 0.9709 0.9434 0.9259 0.9091 0.8696 1 2 1.9135 1.8334 1.7833 1.7355 1.6257 2 3 2.8286 2.6730 2.5771 2.4869 2.2832 3 4 3.7171 3.4651 3.3121 3.1699 2.8550 4 5 4.5797 4.2124 3.9927 3.7908 3.3522 5 6 5.4172 4.9173 4.6229 4.3553 3.7845 6 7 6.2303 5.5824 5.2064 4.8684 4.1604 7 8 7.0197 6.2098 5.7466 5.3349 4.4873 8 9 7.7861 6.8017 6.2469 5.7590 4.7716 9
10 8.5302 7.3601 6.7101 6.1446 5.0188 10
11 9.2526 7.8869 7.1390 6.4951 5.2337 11 12 9.9540 8.3838 7.5361 6.8137 5.4206 12 13 10.6350 8.8527 7.9038 7.1034 5.5831 13 14 11.2961 9.2950 8.2442 7.3667 5.7245 14 15 11.9379 9.7122 8.5595 7.6061 5.8474 15 16 12.5611 10.1059 8.8514 7.8237 5.9542 16 17 13.1661 10.4773 9.1216 8.0216 6.0472 17 18 13.7535 10.8276 9.3719 8.2014 6.1280 18 19 14.3238 11.1581 9.6036 8.3649 6.1982 19 20 14.8775 11.4699 9.8181 8.5136 6.2593 20 30 19.6004 13.7648 11.2578 9.4269 6.5660 30
Present Value Table SECTION 20.2
EXHIBIT 6
If you won $10 million in the lottery and were given a choice of a lump-sum payment or payment over a 20- year period, which would you choose?
Suppose you did win $10 million in the state lottery and your state will pay you this money over a 20-year period—$500,000 a year—or you can get a lumpsum payment up front. What is the actual present value of this $10 million lottery prize? Using a 10 percent interest rate, the present value over a 20-year period is $4,256,800. That is, using the present-value tables, we multiply $500,000 3 8.5136
5 $4,256,800. If you want it up front, it is certainly less than $10 million. Oh yes, there are taxes, too.
WINNING BIG
USING WHAT YOU'VE LEARNED
A Q
To illustrate, suppose we are restaurant owners contemplating the purchase of a jukebox that we think will produce additional annual earnings of $1,000 a year for ten years, at which time it will be obsolete (worthless). In this case, let us assume that we can get 10 percent annually on the use of our funds in some comparable alternative investment; a good proxy for this is the market rate of interest.
We can now calculate the present value of earnings to be received in each year (first, second, third, and so on) and sum them. Since these multiyear computations can be tedious, Exhibit 6 provides a presentvalue table. For example, $1,000 per year over 10 years at 10 percent interest yields a present value of $6,145 ($1,000 3 6.1446). If the price of the jukebox were only $5,000, we would buy it (invest); if the price were $7,000, however, the marginal cost of $7,000 would exceed the present value, $6,145, so we would not invest.
However, if interest rates were to fall to 6 percent, the present value of the flow of future earnings would grow to $7,360 ($1,000 3 7.3601), and we probably would make the investment even if the machine cost $7,000. Thus, falling interest rates lead to greater investment. In short, we see that an investor will buy capital if the expected discounted present value of the capital exceeds the current price.
GOVERNMENT AND FINANCIAL MARKETS
We know from our earlier circular flow discussion that the total output of firms equals the total income of households—that is, in a simple economy with just households and firms, where households spend all their incomes, total spending must equal total output. Recall from our discussion of national income accounts that GDP (or Y) 5 C 1 I 1 G 1
(X 2 M). That is, aggregate expenditures (Y) must equal the sum of its four components, C 1 I 1 G 1
(X 2 M). For simplicity, we begin working in a
closed economy, without the complications introduced by the international, or net export (X 2 M), component. In a closed economy, net exports are zero because there is no international trade—that is, exports are zero and imports are zero. So we can now write (1) Y 5 C 1 I 1 G
That is GDP (Y) is the sum of consumption plus investment plus government purchases. You might ask, what does this have to do with financial markets?
If we subtract C and G from both sides of the equation, we have (2) Y 2 C 2 G 5 I
The left side of the equation (Y 2 C 2 G) is what remains of total income (Y) when you subtract consumption and government purchases. This is called national saving or saving (S) for short. If we substitute
S for Y 2 C 2 G, we can write (3) S 5 I
That is, saving equals investment.
However, to truly understand what happens to saving, we must add net taxes. Net taxes are total tax revenues minus transfer payments (like Social Security benefits, welfare payments, and unemployment insurance). Transfer payments are that part of tax revenues the government takes from one part of the household sector to give to another part of the household sector. Combining equations (2) and (3), we can write the saving equation as (4) S 5 Y 2 C 2 G
This can be rewritten as (5) S 5 (Y 2T 2 C) 1 (T 2 G) Because the two Ts cancel each other out in equation (5), it is easy to see that these two equations are the same. However, equation (5) does give us some useful information. It divides saving into private saving and public saving. Private saving is the amount of income households have left over after consumption and net taxes. Public saving is the amount of income the government has left over after paying for its spending.
Most people are familiar with the idea that households and firms can save but are less familiar with the idea that the government can also save. If the government collects more in taxes than it spends (T > G), it runs a surplus and public saving is positive. If the government spends more than it collects in taxes (G > T), it runs a deficit and public saving is negative. In the next section, we use the tools of supply and demand to examine how budget surpluses and budget deficits affect the real interest rate, national saving, and investment.
Budget Surpluses and Budget Deficits
First, let's see how a budget surplus affects the real interest rate and the amount of saving and investment.
In Exhibit 7, suppose that the government has a balanced budget, the saving supply curve is
SS1, and the investment demand curve is ID1, resulting in an equilibrium real interest rate equal to
Investment Demand and Saving Supply 429
r1 and an equilibrium quantity of saving and investment equal to Q1. If the government now runs a budget surplus—the government receives more in tax revenues than it spends—there is an increase in public saving, assuming that private saving is unchanged.
Because national saving is the sum of private saving and public saving, national saving increases, shifting the saving supply curve from SS1 to
SS2. What impact does this budget surplus (government saving) have on the real interest rate, saving, and investment? The increase in the saving supply from SS1 to SS2 leads to a decrease in the real interest rate to r2 and an increase in equilibrium saving and investment from Q1 to Q2, as shown in Exhibit 7.
The budget surplus leads to an increase in the saving supply, a lower real interest rate and larger amount of saving and investment. This increase in capital formation will tend to increase economic growth.
When the government spends more than it receives in tax revenues, it experiences a budget deficit; the government is actually dissaving (saving negatively or borrowing), which decreases national saving. That is, the budget deficit reduces the national supply of saving, shifting the saving supply curve leftward from SS1 to SS2 in Exhibit 8. At the new equilibrium, there is a higher real interest rate and a lower amount of saving and investment.
When the real interest rate rises because of the government budget deficit, private investment decreases.
Economists call this the crowding-out effect, a topic we will expand on in the chapter entitled Fiscal Policy. In sum, when the government runs a budget deficit, it reduces national saving, which leads to a higher real interest rate and lower investment. Because investment is critical for capital formation, long-term economic growth is reduced by budget deficits.
SAVING AND INVESTMENT IN AN OPEN ECONOMY
In an open economy, individuals, firms, and governments are able to borrow from and lend to foreigners.
When foreigners supply more funds than they demand, there is a capital inflow. When foreigners demand more funds than they supply, there is a capital outflow.
In Exhibit 9, we see that capital inflows from foreign countries add to the supply of national saving, increasing the funds available for domestic capital investment and causing the saving supply curve to be positioned to the right of the national saving supply curve. Capital outflows to foreign countries reduce the saving supply, reducing the funds available for domestic capital investment and causing the saving supply curve to be positioned to the left of the national saving supply curve, as shown in
430 CHAPTER TWENTY | Investment and Saving
0
Q2 Q1
r1
r2
Real Interest Rate, r
Quantity of Saving and Investment
ID
Budget Surplus Positive Public Saving Shifts Saving Supply Right
SS1 SS2
Effects of a Government Budget Surplus
SECTION 20.2
EXHIBIT 7
When the government runs a budget surplus, public saving is positive. This increases national saving and causes the saving supply curve to shift rightward from SS1 to SS2. This leads to a decrease in the real interest rate to r2 and an increase in equilibrium saving and investment from Q1 to Q2. The budget surplus leads to an increase in the saving supply, a lower real interest rate, and larger amounts of saving and investment. This leads to increases in the capital formation and economic growth.
0
Q2 Q1
r1
r2
Real Interest Rate, r
Quantity of Saving and Investment
ID
Budget Deficit Negative Public Saving Shifts Saving Supply Left
SS1
SS2
Effects of a Government Budget Deficit
SECTION 20.2
EXHIBIT 8
When the government runs a budget deficit, public saving is negative. This lowers the supply of national saving, shifting the saving supply curve leftward from SS1 to SS2. At the new equilibrium, there is a higher real interest rate and a lower amount of saving and investment. When the real interest rate rises as a result of the government budget deficit, it causes a decrease in private investment. Economists call this the crowding-out effect.
Exhibit 9. That is, capital inflows encourage capital formation and economic growth and capital outflows hinder capital formation and reduce the rate of economic growth.
Notice in Exhibit 9 that when the real domestic interest rate is low and investment demand is weak, capital will flow out to foreign markets where the real interest rate is higher (that is, there is a higher rate of return on investment). When investment demand is strong, the real domestic interest rate is high, causing an inflow of capital because foreigners will look for a higher rate of return on their investments.
Global financial markets tend to move toward equilibrium, at r1 and Q1 where the quantity of investment demand equals the quantity of saving supplied including the net inflow and outflow of capital.c t i o n C h e c k
Investment Demand and Saving Supply 431
1. The investment demand curve is downward sloping, reflecting the fact that the quantity of investment demanded varies inversely with the real interest rate.
2. At high real interest rates, firms will only pursue those few investment activities with still higher expected rates of return.
At lower real interest rates, projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises.
3. Technology, inventories, expectations, and business taxes can shift the investment demand curve at a given real interest rate.
4. The supply of national saving is composed of both private saving and public saving.
5. The supply curve of savings is upward sloping. At a higher real interest rate, there is an increase in the quantity of savings supplied. At lower real interest rate, there is a decrease in the quantity of saving supplied.
6. Two non-interest determinants of the saving supply curve are disposable (after tax) income and expected future earnings.
7. In equilibrium, desired investment equals desired national saving at the intersection of the investment demand curve and the saving supply curve. If the real interest rate is above the equilibrium real interest rate, the quantity of savings supplied is greater than the quantity of investment demanded at that interest rate; lenders will compete against each other to attract borrowers and the real interest rate falls. If the real interest rate is below the equilibrium real interest rate, the quantity of investment demanded is greater than the quantity of savings supplied at that interest rate; borrowers compete with each other for the available saving and drive the real interest rate up.
8. Private saving is the amount of income households have left over after consumption and net taxes.
9. Public saving is the amount of income the government has left over after paying for its spending.
10. National saving is the sum of private and public saving.
11. Government saving (a budget surplus) increases the saving supply leading to a lower real interest rate and an increase in equilibrium saving and investment.
s e c t i o n c h e c k
(High r capital inflow) 0 Q* r* Saving Supply
Domestic Real Interest Rate, r Quantity of Saving and Investment
(Low r capital outflow)
(includes capital inflows and outflows)
National Saving Supply Q1 Q2
r1
r2
Capital Inflow Capital Outflow ID1
ID ID2
Saving and Investment in the Open Economy SECTION 20.2
EXHIBIT 9
When investment demand is strong, the domestic real interest rate is high and capital inflows from foreign countries increase the supply of saving, increasing the funds available for capital investment. When investment demand is weak, the domestic real interest rate is low and capital flows out to foreign countries, lowering the supply of saving and reducing the funds available for investment. That is, capital inflows encourage capital formation and economic growth, and capital outflows hinder capital formation and reduce the rate of economic growth.
(continued on next page)
432 CHAPTER TWENTY | Investment and Saving
Stock shares are bought and sold in an organized exchange—a stock market—with fluctuations in prices based on supply and demand. Two different types of stock exist: preferred stock and common stock. Stockholders can consist of millions of individuals and institutions that hold an ownership stake in a corporation.
Corporations can borrow money by selling bonds, a financial instrument that is a promise to repay the amount borrowed and pay the holder fixed annual interest payments.
The expectation of future profits—as well as government economic policies, foreign market conditions, and inflation concerns—influences the price of securities. Investors obtain information about stocks from published stock tables that help them make purchasing and selling decisions.
A firm making an investment decision needs to consider both the price it must pay now for the new capital and the additional revenue from the capital that the firm anticipates to make over time. That is, the firm must compare current costs with future benefits.
At a high real interest rate, firms will only pursue those few investment activities that have still higher expected rates of return. At a lower real interest rate, projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises.
At equilibrium in the saving and investment market, desired investment equals desired national saving at the intersection of the investment demand curve and the saving supply curve. At a high real interest rate, firms will only pursue those few invest-
Summar y
12. Government dissaving (a budget deficit) reduces the saving supply leading to a higher real interest rate and a decrease in the equilibrium saving and investment.
13. Capital inflows encourage capital formation and economic growth.
14. Capital outflows hinder capital formation and reduce the rate of economic growth.
1. Why does the investment demand curve slope downward?
2. What factors can shift the investment demand curve?
3. Why does the saving supply curve slope upward?
4. What factors can shift the saving supply curve?
5. How is the real interest rate determined?
6. How are shortages and surpluses eliminated in the investment and saving market?
7. What would happen to the equilibrium interest rate and quantity of investment if both the investment demand and saving supply curves shifted right? What if the investment demand curve shifted right and the saving supply curve shifted left?
8. How is the present value of a future payment affected by changes in the relevant interest rate? By changes in how long before the payment is received?
9. Why does Y - C - G 5 Saving in a simple, closed economy?
10. If net taxes rise, what happens to private saving? To public saving?
11. Other things equal, which direction will an increasing budget surplus change the equilibrium interest rate, the saving supply curve, the level of investment in the economy, and the likely rate of economic growth?
12. Could the crowding-out effect sometimes be called the crowding-in effect?
13. Why is the supply of saving curve flatten in an open rather than a domestic-only economy?
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Review Questions 433
1. In financial markets, is the government a supplier or a demander?
2. Would lower real interest rates be more in the interest of borrowers or lenders?
3. Do owners of perferred stock or common stock in a corporation bear more risk?
4. In the event of a corporate bankruptcy, would you rather be a bondholder, a preferred stockholder, or a stockholder in the ailing corporation?
Explain.
5. What must be true for a “hot” stock tip to really be hot?
6. Why does the assumption that financial markets are operating effciency lead many to recommend a strategy of diversifying among many stocks and holding them for long periods?
7. Obtain the business section of a recent newspaper.
Look up current stock information for Chevron under the NYSE listings. Find the 52- week High, 52-week Low, yield, price-earnings ratio, dividend, closing price and the dollar change from the previous days' closing price.
8. Why might governments sometimes try to combat recessions by lowering interest rates?
9. What would happen to the investment demand curve if new potentially profitable technologies arise and business taxes are raised at the same time?
10. What would happen to the saving supply curve if there was both an increase in current disposable income and people expected higher earnings in the new future?
11. Starting from equilibrium in the saving and investment market, what changes in saving supply or investment demand would tend to cause a surplus of funds at the current interest rate?
What changes in saving supply or investment demand would tend to cause a shortage of funds at the current interest rate?
12. Which is worth more: a large dollar amount to be received further in the future or a smaller amount to be recieved today?
13. What happens to net taxes when transfer payments increase? When both taxes and transfer payments increase?
14. Other things equal, which direction will an increasing budget deficit change the equilibrium interest rate, the saving supply curve, the level of investment in the economy, and the likely rate of economic growth, other things equal?
R e v i e w Q u e s t i o n s
ment activities that have still higher expected rates of return. At lower real interest rates, projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises.
National saving equals private saving plus public (government) saving. A government budget deficit leads to negative public saving. This reduces national saving and the supply of saving available to finance investment. By increasing the real interest rate and crowding out private investment, a government budget deficit reduces the growth of productivity and hinders economic growth. Capital inflows encourage capital formation and economic growth. When a government runs a budget surplus (collects more in taxes than it spends) it adds to the saving supply, leading to a lower real interest rate and an increase in the equilibrium quantity of saving and investment.
K e y Ter m s a n d C o n c e p t s
stockholder 420 preferred stock 420 common stock 420 bonds 421 securities 421 dividend 422 price-earnings (PE) ratio 422 national saving 426 present value 427 closed economy 429 private saving 429 public saving 429 dissaving 430 crowding-out effect 430
15. Why will a given government budget deficit have a smaller effect on investment in an open economy than a closed economy?
16. Visit the Sexton Web site for this chapter at
http://sexton.swlearning.com and click on the Interactive Study Center button. Under Internet Review Questions, click on the Invest Smart link and create your own “virtual stock portfolio” with $100,000 in virtual funds by participating in the InvestSmart Stock Market Game. (You will need to register to participate.)
Check on (and perhaps adjust) your portfolio periodically and see how the value of your portfolio changes.
17. Visit the Sexton Web site for this chapter at
http://sexton.swlearning.com and click on the Interactive Study Center button. Under Internet Review Questions, click on the Motley Fool link and then click on the Stock Research link. Look up reports on Wal-Mart by entering Wal-Mart's stock symbol (WMT) in the “Company Info” search line. Next research a company of your own choosing at the Motley Fool Web site.
18. Visit the Sexton Web site for this chapter at
http://sexton.swlearning.com and click on the Interactive Study Center button. Under Internet Review Questions, click on the New York Stock Exchange link. Find out the volume of shares traded on this exchange in the most recent trading period. Examine the latest figures for the New York Stock Exchange composite.
Do stocks prices on the NYSE appear to be rising or falling? How about industrial stocks represented by the Dow Jones Industrial Average (DJIA)?
434 CHAPTER TWENTY | Investment and Saving
Section Check Answers SC-33
CHAPTER 20: INVESTMENT AND SAVING
20.1: Financial Markets
1. In financial markets, who are the primary suppliers and who are the primary demanders?
Households are the primary suppliers of funds and firms are the primary demanders.
2. Why are financial markets appropriately considered to be global in scope?
Financial markets appropriately considered to be global in scope because if real interest rates are higher in one country than another, for a given level of risk, funds will move toward the higher real interest rate location.
3. Who has more voting rights in determining a corporations policy Ban owner of 1% of the common stock, or an owner of 10% of the corporation's bonds? Who is a larger owner of the corporation?
The owner of common stock, in both cases. Bondholders do not have a vote in determining corporate policy, and they are creditors of a corporation, not owners.
4. If you believed a company's profitability was about to jump sharply, would you rather own bonds, preferred stock, or common stock in that company?
You would rather own common stock, since owners of common stock are the residual claimants on the resources of the corporation. If profits were about to jump sharply, common stock owners would benefit, because that residual will get substantially larger. Preferred stocks, which pay regular, fixed dividends, and bonds, which pay fixed interest payments, would not benefit nearly as much from increased future profitability.
5. If almost all investors expected the profits of a company to jump sharply, would that make purchasing the stock today unusually profitable?
No. Generally shared expectations of higher future profits will result in higher current prices, which capitalize those expected profits. Once those expected profits are reflected in current stock prices, buyers of that stock will not earn unusually high profits as a result.
6. Why are issues of new stocks to finance business investments more common in periods of high and rising stock prices?
In periods of high and rising stock prices, a firm can raise more money for a given number of new ownership shares issued.
7. What are some of the reasons that stock prices rise and fall?
Stock prices rise and fall with expectations of corporate earnings, business conditions, economic policies of the government, business conditions in foreign countries, concern over inflation, and more. Anything which changes expectations of benefits or costs from holding securities will change stock prices.
8. What is the random walk?
The random walk idea is that if markets are operating efficiently, the current stock prices will reflect all available information, so that consistent, extraordinary profit opportunities will not exist. That is, without illegal inside information or consistent good luck, one should not expect to be able to consistently pick winners in the stock market.
9. What is a dividend?
The dividend reported on financial pages is the annual amount the company in question has paid over the preceding year on each share of stock.
10. How do you calculate a price-earnings ratio?
The price-earnings ratio reported on financial pages is found by taking the price of the stock and dividing it by the amount the company earned per share over the past year.
20.2: Investment Demand and Saving Supply 1. Why does the investment demand curve slope downward?
As the real interest rate falls, additional investment projects with lower expected rates of return become profitable for firms, and the quantity of investment demanded rises.
2. What factors can shift the investment demand curve?
The investment demand curve would increase (shift to the right) if firms expect higher rates of return on their investments; if product and process innovation reduce the costs of production; if profitable new products are developed; if inventories are depleted below the levels desired by firms; if forecasts for future expected sales are strong; or if business taxes are lowered. The investment demand curve would decrease (shift to the left) in the opposite situations.
3. Why does the saving supply curve slope upward?
At a higher real interest rate, the reward for saving and supplying funds to financial markets is greater, leading to an increased quantity of saving supplied.
4. What factors can shift the saving supply curve?
The saving supply curve would increase (shift to the right) if disposable (after tax) income rose or if people expected lower future earnings. The saving supply curve would decrease (shift to the left) if disposable (after tax) income fell or if people expected higher future earnings.
5. How is the real interest rate determined?
The real interest rate is determined by the intersection of the investment demand curve and the saving supply curve, where desired investment equals desired national saving.
6. How are shortages and surpluses eliminated in the investment and saving market?
If the real interest rate was above the equilibrium real interest rate, the quantity of savings supplied would be greater than the quantity of investment demanded-there would be a surplus of savings. As savers (lenders) compete against each other to attract investment demanders (borrowers), the real interest rate will fall toward the equilibrium level. If the real interest rate was below the equilibrium real interest rate, the quantity of savings supplied would be less than the quantity of investment demanded-there would be a shortage of savings.
As demanders (borrowers) compete against each other to attract savers (lenders), the real interest rate will rise toward the equilibrium level.
7. What would happen to the equilibrium interest rate and quantity of investment if both the investment demand and saving supply curves shifted right? What if the investment demand curve shifted right and the saving supply curve shifted left?
Whenever both the supply and demand curves shift in any market, we add up the separate effects on price (interest rate) and quantity (of investment funds) exchanged. When both the investment demand and saving supply curves shifted right, each would increase the quantity of investment funds exchanged, but would have opposing effects on the interest rate, making that change indeterminate without knowing about the relative magnitudes of the changes.
SC-34 Section Check Answers When the investment demand curve shifted right and the saving supply curve shifted left, both effects would tend to increase the interest rate, but have opposing effects on the quantity of investment funds exchanged, making that change indeterminate without knowing about the relative magnitudes of the changes.
8. How is the present value of a future payment affected by changes in the relevant interest rate? By changes in how long before the payment is received?
As indicated in the present value formula, the present value of a payment to be received in the future is worth more, the lower the relevant interest rate and the sooner it is received.
9. Why does Y 2 C 2 G = saving in a simple, closed economy?
Y 2 C 2 G is what is left over from income after spending on consumption and government purchases, which is what is available for investment. But in equilibrium, investment must equal saving.
10. If net taxes rise, what happens to private saving? To public saving?
Increased net taxes reduce disposable income, which, in turn reduces private saving. However, increased net taxes move the government budget toward surplus, increasing public saving.
11. Other things equal, which direction will an increasing budget surplus change the equilibrium interest rate, the saving supply curve, the level of investment in the economy, and the likely rate of economic growth, other things equal?
An increasing budget surplus would increase the saving supply curve, which would decrease the equilibrium interest rate and increase the equilibrium level of investment in the economy, which would tend to increase economy growth.
12. Could the crowding-out effect sometimes be called the crowding-in effect?
Just as larger government budget deficits crowd out investments by raising interest rates, smaller budget deficits or larger government surpluses would tend to reduce interest rates, increasing or crowding-in investment.
13. Why is the supply of saving curve flatter in an open than a domestic only economy?
As the interest rate in the U.S. rises, funds from overseas will also be attracted by the higher returns, so interest rates will rise less than they would in a domestic only economy.