Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 15 Interest Rates and the Capital Market

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Compute the present value of an asset that delivers a stream of future benefits. 4. Describe how the equilibrium interest rate is determined and how it is affected by various economic events. 3. Explain why the supply of saving is positively related to the interest rate. 2. Explain why the demand for investment is negatively related to the interest rate.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Investment is the purchase of new capital equipment. It can be financed by: using retained earnings borrowing from banks issuing bonds or stock A Brief Overview of the Capital Market Firms’ demand for financial capital is derived from their demand for physical capital.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.1 The Interaction of Firms and Households in the Capital Market

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Present Value of a Single Future Payment Consider purchasing a new capital good: - it produces an MRP of $100 in one year - it produces nothing thereafter - how much are you prepared to pay? If the interest rate is 5% per annum, then the PV is: PV x (1.05) = $100 PV = $95.24 Present Value

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In general, if the interest rate is i percent per year, then the PV of the MRP received one year hence is: PV = MRP/(1 + i) Table 15.1 The Present Value of a Single Sum One Year in the Future

Copyright © 2008 Pearson Addison-Wesley. All rights reserved What if the MRP occurs t periods in the future? The PV of MRP dollars received t years in the future when the interest rate is i per year is: PV = MRP/(1 + i) t More Than One Period in the Future

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 15.2 The Present Value of a Single Sum Several Years in the Future

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Present Value of a Stream of Future Payments The same basic approach is followed: - identify when each MRP occurs - “discount” each MRP back to the present, using the relevant interest rate - sum up the terms from each future period

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 15.3 The Present Value of a Stream of Future Payments

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Conclusions 1. Capital is valuable because it generates a stream of future benefits as measured by MRP. 2. The larger is each MRP, or the longer the stream persists, the greater is the PV of the capital. 3. The PV is negatively related to the interest rate. 4. The further ahead in time the MRP occurs, the lower is the PV.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Firm’s Demand for Capital A profit-maximizing firm buys an additional unit of capital if its PV exceeds the purchase price. The firm’s optimal capital stock is such that the PV of the flow of MRPs that is generated by the last unit of capital is equal to its purchase price. The Demand for Capital

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The firm’s optimal capital stock is inversely related to the interest rate. Figure 15.2 The Firm’s Optimal Capital Stock

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.3 The Interest Rate and the Firm’s Investment Demand

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.4 The Economy’s Supply of Saving

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Supply of Capital Saving and Current Income Household saving is typically positively related to current income. An increase in current income increases desired saving (and thus increases the supply of financial capital).

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Saving and Expected Future Income An increase in expected future income: - increases current consumption  reduces current saving Saving and the Interest Rate An increase in the interest rate causes households to: - reduce their current consumption  increases their current saving

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The economy’s supply of saving shows a positive relationship between the interest rate and the quantity of saving supplied. The Economy’s Supply of Saving What causes S to shift? 1. A rise in current income  S shifts to right 2. A rise in future income  S shifts to left Flow of Saving S Interest Rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Investment, Saving, and the Interest Rate Individuals firms and households take the interest rate as exogenous, but for the overall economy, the interest rate is endogenous. What is the difference between nominal and real interest rates? EXTENSIONS IN THEORY 15.1 Inflation and Interest Rates

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.5 The Market for Financial Capital

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.6 Changes in Demand and Supply in the Market for Financial Capital

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Three possible causes of an increase in the supply of saving: 1. income growth 2. population growth 3. government policies – e.g., IRA accounts Increases in the Supply of Financial Capital

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Three possible causes of increased investment demand: 1.income and population growth 2. technological improvements that increase MRP 3. government policies – e.g., investment tax credits Increases in the Supply of Financial Capital

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 15.7 The Capital Stock and Real Interest Rate, 1965–2005

Copyright © 2008 Pearson Addison-Wesley. All rights reserved APPLYING ECONOMIC CONCEPTS 15.1 Investment and Saving in Globalized Capital Markets Globalized Capital Markets