Investment and Financial Markets After the end of the high tech boom and the sharp decline in the stock market in 2000, individuals and firms began looking for other areas to invest and earn high returns. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU

A P P L Y I N G T H E C O N C E P T S How do fluctuations in energy prices affect investment decisions by firms? Energy Price Uncertainty Reduces Investment Spending How can understanding the concept of present value help a lucky lottery winner? Options for a Lottery Winner Why are there different types of interest rates in the economy? Interest Rates Vary by Risk and Length of Loan How have recent financial innovations created new risks for the economy? Securitization: The Good, the Bad, and the Ugly 1 2 3 4

12.1 AN INVESTMENT: A PLUNGE INTO THE UNKNOWN accelerator theory The theory of investment that says that current investment spending depends positively on the expected future growth of real GDP.  FIGURE 12.1 Investment Spending as a Share of U.S. GDP, 1970–2007 The share of investment as a component of GDP ranged from a low of about 10 percent in 1975 to a high of over 18 percent in 2000. The shaded areas represent U.S. recessions.

If prices fall, these investments would be unwise. A P P L I C A T I O N 1 ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING APPLYING THE CONCEPTS #1: How do fluctuations in energy prices affect investment decisions by firms? One important way volatility of oil prices can hurt the economy is by creating uncertainty for firms making investment decisions. Consider whether a firm should invest in an energy-saving technology for a new plant: If energy prices remain high, it may be profitable to invest in energy-saving technology. If prices fall, these investments would be unwise. If future oil prices are uncertain, a firm may simply delay building the plant until the path of oil prices are clear. When firms are faced with an increasingly uncertain future, they will delay their investment decisions until the uncertainty is resolved.

12.1 AN INVESTMENT: A PLUNGE INTO THE UNKNOWN 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.

12.2 Understanding Present Value EVALUATING THE FUTURE PRESENT VALUE AND INTEREST RATES present value The maximum amount a person is willing to pay today to receive a payment in the future. P R I N C I P L E O F O P P O RT U N I T Y C O S T The opportunity cost of something is what you sacrifice to get it. 1 The present value—the value today—of a given payment in the future is the maximum amount a person is willing to pay today for that payment. 2 As the interest rate increases, the opportunity cost of your funds also increases, so the present value of a given payment in the future falls. In other words, you need less money today to get to your future “money goal.” 3 As the interest rate decreases, the opportunity cost of your funds also decreases, so the present value of a given payment in the future rises. In other words, you need more money today to get to your money goal.

A P P L I C A T I O N 2 OPTIONS FOR A LOTTERY WINNER APPLYING THE CONCEPTS #2: How can understanding the concept of present value help a lucky lottery winner? The lucky winner of a lottery was given an option: Receive $1 million a year for 20 years Receive $10 million today Why would anyone take the $10 million today? To determine which payment option is best, our lottery winner would first need to: Calculate the present value of $1 million for each of the 20 years Add up the result Compare it to the $10 million being offered to her today Example: With an 8 percent interest rate, the present value of an annual payment of $1 million every year for 20 years is $9.8 million. Best option: If interest rates exceed 8 percent, it is better to take the $10 million dollars.

12.2 Real and Nominal Interest Rates EVALUATING THE FUTURE R E A L - N O M I N A L P R I N C I P L E What matters to people is the real value of money or income—the purchasing power—not the face value of money. nominal interest rate Interest rates quoted in the market. real interest rate The nominal interest rate minus the inflation rate.

12.2 Real and Nominal Interest Rates EVALUATING THE FUTURE expected real interest rate The nominal interest rate minus the expected inflation rate.

A P P L I C A T I O N 3 INTEREST RATES VARY BY RISK AND LENGTH OF LOAN APPLYING THE CONCEPTS #3: Why are there different types of interest rates in the economy? FIGURE 12.2 Interest Rates on Corporate and Government Investments, 2002-2007 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. The reason is that corporations are less likely to pay back their loans than the U.S. government. Notice, too, that for most of this time period, the U.S. government typically paid a lower rate when it borrowed for shorter periods of time (six months) than for longer periods of time (10 years).

12.3 UNDERSTANDING INVESTMENT DECISIONS  FIGURE 12.3 The Relationship between Real Interest Rates, and Investment Spending As the real interest rate declines, investment spending in the economy increases. neoclassical theory of investment A theory of investment that says both real interest rates and taxes are important determinants of investment.

12.3 Investment and the Stock Market UNDERSTANDING INVESTMENT DECISIONS Investment and the Stock Market retained earnings Corporate earnings that are not paid out as dividends to their 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.

12.3 UNDERSTANDING INVESTMENT DECISIONS FIGURE 12.4 The Stock Market and Investment Levels, 1997–2003 Both the stock market and investment spending rose sharply from 1997, peaking in mid-2000.

12.4 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT liquid Easily convertible into money on short notice. FIGURE 12.5 Savers and Investors

12.4 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT financial intermediaries Organizations that receive funds from savers and channel them to investors. FIGURE 12.6 Financial Intermediaries

12.4 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT securitization The practice of purchasing loans, re-packaging them, and selling them to the financial markets. leverage Using borrowed funds to purchase assets.

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

A P P L I C A T I O N 4 SECURITIZATION: THE GOOD, THE BAD, AND THE UGLY APPLYING THE CONCEPTS #4: How have recent financial innovations created new risks for the economy? As securitization developed, it allowed financial intermediaries to provide new funds for borrowers to enter the housing market. As the housing boom began in 2002, lenders and home purchasers began to take increasing risks. Lenders made “subprime” loans to borrowers with limited ability to actually repay their mortgages. Some households were willing to take on considerable debt because they were confident they could make money in a rising housing market. Lenders securitized the subprime loans and financial firms offered exotic investment securities to investors based on these loans. Many financial institutions purchased these securities without really knowing what was inside them. When the housing boom stopped and borrowers stopped making payments on subprime loans, it created panic in the financial market. Effectively, through securitization the damage from the subprime loans spread to the entire financial market, causing a major crisis.

K E Y T E R M S accelerator theory bank run corporate bond deposit insurance expected real interest rate financial intermediaries leverage liquid multiplier-accelerator model neoclassical theory of investment nominal interest rate present value procyclical Q-theory of investment real interest rate retained earnings securitization