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Investment, Savings, and Real Interest Rate.

Investment, Savings, and Real Interest Rate. Defns: Physical capital : tools, instruments, machines, buildings,ect. Financial capital is the funds that firms use to buy and operate physical capital. Gross investment is the total amount spent on new physical capital goods.

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Investment, Savings, and Real Interest Rate.

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  1. Investment, Savings, and Real Interest Rate. Defns: Physical capital: tools, instruments, machines, buildings,ect. Financial capitalis the funds that firms use to buy and operate physical capital. Gross investment is the total amount spent on new physical capital goods. Net investment is the change in the quantity of capital—equals gross investment minus depreciation. Wealthis the value of all the things that a person owns. Savingis the amount of income that is not paid in taxes or spent on consumption goods and services; saving adds to wealth. Savings = income – taxes - consumption

  2. PHYSICAL CAPITAL AND FINANCIAL CAPITAL Concept: Savings is provided to firms in order to acquire physical captial. This is done in these markets. • Stock markets • Bond markets Ques: What are the differences between stocks and bonds?

  3. Interest Rates. Ques: Why do people charge an interest rate on loans? Hint-Opportunity cost of lending Concept: One Description of the Interest Rate on a Financial Asset. The interest rate on a financial asset is a percentage of the price of the asset. Ex. Suppose one share entitled the owner to 40 cents. If on oct. 1 the asset cost $40. what is the interest rate? R=(.40/40)*100=1% Suppose the price of the asset fell to $20? Here we see the inverse relationship between asset prices and the interest rate.

  4. Examples 1) Mark buys building and equipment for $400,000 in 2007. In 2008 he sold for $100,000. How much is gross investment, depreciation, net investment? 2) Becky earned $50,000, paid $6k in taxes and consumed $43 k worth of goods. What is her Savings? Suppose she has $30,000 in her bank account, what is her wealth? 3) Jeremy purchases a bond that pays $600 in interest. If Jeremy paid$9,000 for the bond, what is the interest rate? If Jeremy paid $10,000 for the bond, what is the interest rate? How did a rise in the price of the bond affect the interest rate?

  5. THE MARKET FOR LOANABLE FUNDS Demand for loanable funds ( i.e stock, bond,ect) 1. Business investment 2. Government budget deficit 3. International investment or lending Supply of loanable funds 1. Private saving 2. Government budget surplus 3. International borrowing

  6. Demand for funds The Demand for Loanable Funds The quantity of loanable funds demanded depends on 1. The real interest rate Firms borrow as long as real interest rate < expected profit. ques: how is it analogous to labor demand? If the nominal interest rate is 15% on a bank loan. And expected profit on investment is 15%. For an inflation rate of 5% and a capital investment of $1mil. Calculate the expected real return on the investment. Ans- Real interest rate = 15%-5%=10% Cost on investment = .10*$1 mil= $100k Rev=$150K ….return = $150-$100=$50K

  7. THE MARKET FOR LOANABLE FUNDS Changes in the Demand for Loanable Funds A change in expected profits Shifts the demand curve. Whats the reasoning behind the shift?? Other shifters- • Larger population • Technological change • “animal spirits”

  8. THE MARKET FOR LOANABLE FUNDS Recall: The supply of loanable funds is the amount of funds available from private saving, the government budget surplus, and international borrowing Ques: Why is the supply curve upward sloping? (Hint: the opportunity cost of consumption). Shifters 1. Disposable income (+) 2. Wealth (-) 3. Expected future income (-) Recall: relate the price of funds to the • Opportunity cost of savings • Marginal benefit to borrowers

  9. Questions The Chinese buy a lot of U.S government securities. Describe how this form of trade with the U.S is related to the U.S market for loanable funds. 2) The market for loanable funds currently has an interest rate of 5%, and $10Billion. Describe what happens in the market if i)there is a global business boom, and firms expect their profits to increase. ii) Another world war begins, U.S against the world. iii) If firms use loanable funds to finance capital purchases. Describe what happens to Real GDP in each case.

  10. GOVERNMENT IN LOANABLE FUNDS MARKET Total saving equals private saving plus government saving. Ques: Use a diagram to show how a government surplus/deficit impact the the total supply of loanable funds? How is the real interest rate and the total amount of funds impacted? Concept: Crowding out effect: The increased interest rate and reduced investment brought about by a government deficit.

  11. GOVERNMENT IN LOANABLE FUNDS MARKET The Ricardo-Barro Effect The proposition that a government budget deficit has no effect on the real interest rate or investment. Why? People will increase savings due to expectations of higher future taxes.

  12. APPENDIX: PRESENT VALUE Present value is the present value of a future sum of money is the amount that will earn enough interest to grow to that future sum. Future value= $X * (1 + r)N

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