CHAPTER 26 INTEREST, PRESENT VALUE, RENT, PROFIT 1

SUBJECT 1 - INTEREST Interest : the payment for the use of loanable funds Where do loanable funds originate?  Households that save (do not consume) part of their income  Invest for retirement  Save for large purchases (homes and college)  Desire to earn interest (less than will be charged) 2

How are interest rates and loanable funds connected? As the interest rates go up, household savings increase 3 Interest rates Quantity of loanable funds The loanable funds supply curve is upwardly sloping

WHERE DOES THE DEMAND FOR LOANABLE FUNDS COME FROM? 1) Consumers who have a positive rate of time preference – consumers that prefer earlier consumption to later consumption. Borrow money to consume now…pay later with interest. Example: Ivan wants to buy a $2000 car. Instead of waiting until he has saved the money. He borrows the money, plus interest, paying it back over the next 3 years. The car will now eventually cost him $2900 2) Business firms, that wish to invest in physical capital – firms will borrow money to purchase new capital to become more productive and more profitable in the long run. 4

INTEREST RATES ARE IMPORTANT TO LOAN MARKETS Consumers want to borrow money when rates are low…but funds may be scarce because investors want put savings and investment elsewhere due to low returns. Consumer and investment demand for loanable funds are inversely related to the interest rate. Downward sloping. 5 Interest rates Quantity of loanable funds D1D1 S D2D2

INTEREST RATE EXAMPLES Last year a home mortgage rate averaged 3.8% - that is great for people that need to borrow money over a long period of time. I borrow $100,000 over 30 years, I pay $155,000. At 4.5%, I pay $182,000. A 1.5% interest rate for a savings account is “safe” but poor return. Not very enticing to investors The stock market last year yielded minus 1% return on average…but normally will offer from 5-8% return. In tough market times, investors put money in safe, low-yield places creating lots of loanable funds. Creating “cheap money” 6

ALL INTEREST RATES ARE NOT THE SAME What causes variations in interest rates charged for loans? Risk Premium – The greater the risk that the loan may not be paid back, the higher the interest that is charged. Term of the Loan (Time Premium) – the longer the term of the loan, the lower the interest rate. 5 year car loans are approx. 8-10%...30 year mortgages are currently 3.8%. Relative “cost” of making the loan – It may cost $300 to process both a $5,000 loan and a $155,000 loan. The relative cost of the small loan is greater. 7

SUBJECT 2 – PRESENT VALUE OF MONEY If I ask you, hey can I borrow $950 if I pay you $1000 in one year? If current interest rates that you can expect on an investment return is 8%, should you say yes to me? What about at 5%? What about at 3%? PV = F / (1 + i)n PV = Present Value F = Future Amount i = interest rate n = number of years divided by 1.08 = $ If this amount is less than the amount offered, it is a bad deal. At current expected rates, I will loan you if you pay me back $1000 FV = PV (1+ i)n

WHAT IS THE “REAL” INTEREST RATE The rate of interest that reflects the true return on investing and the true gain from lending is the “real” interest rate Nominal Interest Rate – amount of interest earned Rate of inflation – usually around 2% Investment interest rate is 6% (Minus) Inflation rate of 2% (equals) Real interest rate of 4% 9

MORE PRESENT VALUE PROBLEMS PV = F/ (1+i)n What is the present value of: A.$6000 when I can expect 5% for 3 years B.$2300 when I can expect 3% for 5 years C.$12,400 when I can expect 7% for 8 years $ $ $

MORE EXAMPLES 1 – Arlene can invest in an asset today that she can sell in one year for $5000. What is the present value of $5000 to be received one year from today, assuming Arlene could earn 5% interest if she had the money today? 2 – what if she could earn 12%? 3 – what if she has to wait 8 years? PV = F / (1 + i)n 11

SUBJECT 3 ECONOMIC RENT Economic Rent – Payment made for a factor that is over and above the amount expected by the owner. This is what all factor owners should seek. Example 11 – If a professor wants 10 students to participate in a experiment. Only 2 would do it for $20. He had to pay $60 per person to get 10 participants. The two students willing to accept $20 receive an economic rent of $40. (60-20=40) Video: Gifted Basketball Player wants $10 mill but is offered $13 mill Home buyer wants to make sure they get the $220k house by offering $225k I went to the store to buy a steak for $10 and it is on sale for $8 12

FUNCTIONS OF ECONOMIC RENT 1.Economic Rent allocates resources to their most valuable use – Former President Bill Clinton’s public speaking choices (5000 offers, accepts the 10 with the highest offer) 2. Economic Rent provides incentive for resource owners to develop the productivity of their resources – Former President George W Bush stinks as a speaker (at first he gets 5000 offers, then the offers and the fees go down when they find out he stinks. He hires a coach and improves until his fees go up again) 13

SUBJECT 4 ECONOMIC PROFIT The difference in total revenue and total costs. A firm may tap into one of four sources of economic profit. Profit is hard to make in the long run…but in the short run, use these strategies 1.Arbitrage –It refers to buying low in one market and selling at a higher price in another. Ex: Plywood sales after a hurricane. These are short-lived, highly profitable opportunities. Ex: A doll in Dallas is $15, it sells for $25 in Seattle, $5 to ship and I make $5 for just making it available in the Seattle market 2.Uncertainty – Start-up enterprises have high risk and high profit potential. Entrepreneurs that hit it big, make big profits. 3.Innovation – Innovation leads markets and takes profits until competition catches up with innovations of their own. 4.Monopoly Profits – Strive to become, or acquire a company with monopoly power. High market share with price setting abilities. 14

PROFIT AS A SIGNAL Profit acts a signaling device in a market economy. Profit attracts entrepreneurs and resources into markets of growing consumer demand. “Profit seeking” is the basis for free market economies Keeping markets free and open is the key 15