12 INVESTMENT AND FINANCIAL MARKETS

INVESTMENTS accelerator theory The theory of investment that says that current investment spending depends positively on the expected future growth of real GDP.  Investment Spending as a Share of U.S. GDP, 1970–2005

INVESTMENTS procyclical Moving in the same direction as real GDP. multiplier-accelerator model A model in which a downturn in real GDP leads to a sharp fall in investment, which triggers further reductions in GDP through the multiplier. countercyclical Moving in the opposite direction as real GDP.

EVALUATING THE FUTURE Real and Nominal Interest Rates nominal interest rate Interest rates quoted in the market. real interest rate The nominal interest rate minus the inflation rate. expected real interest rate The nominal interest rate minus the expected inflation rate.

INTEREST RATES VARY BY RISK AND LENGTH OF LOAN Why are there different types of interest rates in the economy? Riskier loans and loans for longer maturities typically have higher interest rates. Notice that rates for corporate bonds are higher than the rates for 10-year Treasury bonds. Reason: Corporations are less likely to pay back their loans than the U.S. government.  Interest Rates on Corporate and Government Investments, EVALUATING THE FUTURE

UNDERSTANDING INVESTMENT DECISIONS neoclassical theory of investment A theory of investment that says both real interest rates and taxes are important determinants of investment.

SOURCES OF MONEY FOR INVESTMENT When financing a new project, a firm can: 1.Use its retained earnings—the earnings the firm hasn’t paid out in dividends. 2.Sell corporate bonds to the public. 3.Issue and sell new shares of stock.

UNDERSTANDING INVESTMENT DECISIONS Investment and the Stock Market retained earnings Corporate earnings that are not paid out as dividends to its owners. corporate bond A bond sold by a corporation to the public in order to borrow money. Q-theory of investment The theory of investment that links investment spending to stock prices.

HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT liquid Easily convertible into money on short notice.

HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT financial intermediaries Organizations that receive funds from savers and channel them to investors.

BENEFITS OF FINANCIAL INTERMEDIARIES 1.By pooling the funds of savers and making loans to individual businesses, financial intermediaries reduce the costs of negotiation. 2.Financial intermediaries assume the risk of the transaction. 3.Some financial intermediaries also provide the liquidity households demand.

HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT bank run Panicky investors simultaneously trying to withdraw their funds from a bank they believe may fail. When Financial Intermediaries Malfunction deposit insurance Federal government insurance on deposits in banks and savings and loans.