ECON 252 Module 9: Savings and Investment

Why is investment so volatile?

some consumption spending can’t be postponed but investment spending can be, technological innovations, credit constraints

Why is investment important?

source of captial (K), role in business cycle

Trading an existing asset does not count as investment

investment expands the economy’s productive capacity

Investment

flow of new purchases of capital that add to this stock; examples being addition of new capital, replacing old capital, and adding to inventories

Depreciation

decline in capital due to wear and tear, obsolescence, accidental damages, and aging

Types of investment spending

business investment, inventories, housing investment

Capital today equation

K_t = (1 - d)*K_{t - 1} + I_t

Business investment

spending by businesses on new capital assets, including intellectual property

Inventories

spending on accumulated raw materials, work-in-progress, and unsold goods; smallest category but most volatile

Housing investment

spending on building or improving houses or apartments

Production equation

Products = Sales + Closing Inventory - Opening Inventory

Business inventories as an economic indicator

changes in business inventories are a leading economic indicator

Investment is a key economic factor

drives business cycle, changes quickly, key driver of long-term prosperity

Investment is sensitive to

future expectations, interest rates, leading standards, depreciation

Compounding interest equation

PV(1 + r)^t = FV

Discounting equation

PV = FV/(1 + r)^t

What is an interest rate?

a willingness to trade off consumption today for consumption in the future

Invest in new capital if the present value of the benefits exceed the present value of the costs

convert future revenues into their present values

Investment relationship with real interest rates

investment declines as real interest rates rise

Determinants of demand for loanable funds

demand for goods increase, government policies, expectations, budget deficits

Demand for goods increase

higher return for all → “cut off” point increases

Point-of-view #1 about budget deficits/surpluses

when deficits (taxes<government spending), government needs to borrow money, increases real interest rate and. shifts demand for loanable funds up, crowing out effect (government borrowing crowds out private investors)

Investment shifters

technological advancements, expectations, corporate taxes, lending standards and cash reserves

High corporate tax rate impact on investment line

high corporate tax rate shifts investment line and demand for loanable funds left, corporate tax breaks shifts investment and demand for loanable funds right

Supply of loanable funds

represents savers, if real interest rate is higher, the more people save

Determinants for supply of loanable funds

changes in personal saving rates, budget deficits and surpluses, foreign savings

Savings equation

S = (Y - C - T) + (T - G) + (M - X)

Trade deficit

M > X

Foreign savings

trade deficit increases supply of loanable funds

Point-of-view #2 about deficits and surpluses

deficits decreases supply of loanable funds, lead to higher interest rate and crowding out effect

Net capital inflows (NCI)

imports minus exports (M - X)

What is the equilibrium real interest rate?

amount of savings and demand for loans equal

How do firms borrow?

Bank bonds

Demand for loanable funds increases

real interest rate increases, quantity increases

Demand for loanable funds decreases

real interest rate decreases, quantity decreases

Supply for loanable funds increases

real interest rate decreases, quantity increases

Supply for loanable funds decreases

real interest rate increases, quantity decreases

Price of bond impact on yield and interest rate

price of bond increases, yield and interest rate decreases

If supply of bonds increase

firms want to invest more, bond prices decrease; if firms cut back on investment, bond prices increase

Default risk

higher risk of default, need to be compensated more for that → lower bond prices (higher yield)

Inflation risk

higher interest rate → lower bond prices