Investment, the Capital Market, and the Wealth of Nations Micro Chapter 14 Investment, the Capital Market, and the Wealth of Nations

Learning Goals: Describe the difference between investing and saving Identify factors that determine interest rates Explain the relationship between present value and a) interest rates and b) time periods

Why People Invest

Categories of Capital: Physical capital- nonhuman resources used to produce goods and services Human capital- the knowledge and skills of people

Investment ≠ Saving Saving is not using current income for consumption Investment is using saving to produce capital resource Saving today (giving up some current consumption) allows for investment which results in more future consumption

Time Preference If you’re like most people, you’d like to have something today rather than waiting until next month (or some time in the future) If so, you have a positive time preference Time preference can be measured by an interest rate

Q14.1 If Jennifer has a positive rate of time preference, she will value the receipt of $1,000 twenty years from now just as much as she would value receipt of the $1,000 today. value the receipt of $1,000 twenty years from now more than she would value receipt of the $1,000 today. value the receipt of $1,000 twenty years from now less than she would value receipt of the $1,000 today. prefer to receive any amount of money now to the $1,000 twenty years from today.

Interest Rates

Example: home mortgage An interest rate is the market price for obtaining funds today or the price received for delaying current consumption Example: home mortgage You pay an interest rate to receive money to buy a house today instead of saving enough money to pay for the house later Example: savings account You receive an interest rate as payment for saving your money and foregoing current consumption

Interest rates are determined by the supply and demand for loanable funds Money (nominal) interest rate- the interest rate expressed in today’s terms Real interest rate = money rate – inflation rate

Risk also determines the interest rate The higher the risk, the higher the interest rate; the lower the risk, the lower the interest rate

The Present Value of Future Income and Costs

Present Value Allows for accurate comparisons of value across time periods A dollar in your pocket today is not worth a dollar 2 years from now. How can we compare those time periods?

Don’t memorize the PV formula! No quiz or exam questions will ask you to “plug and chug” numbers into a formula Do know the relationships: The PV of a future dollar will become smaller when the interest rate increases The PV of a future dollar will become smaller when the time period becomes longer

Q14.2 The present value of $10,000 to be received 10 years from now will decrease if the interest rate rises. be greater if the funds were going to be received 15 years from now. be greater than $10,000. increase if the interest rate were to rise from 4 percent to 8 percent.

Present Value, Profitability, and Investment

If you make an investment today (i. e If you make an investment today (i.e. incur a cost) and that investment provides benefits over a future time period, how can you tell if you’ll receive a net benefit or a net cost? You need to accurately compare the costs and benefits in the same time period. Either express the cost today in the future period, or express the future benefits into the current period.

Investing in Human Capital

The analysis for human capital is the same as for physical capital You incur a cost today and give up current consumption in return for benefits in the future (more future consumption). Discount future earnings and compare to current costs Investing in yourself is the best investment you’ll ever make!

Q14.3 An investment in human capital will be financially profitable if the present discounted value of the future earnings generated by the investment exceeds the present discounted value of both the direct and indirect costs of the investment. dollar amount of the direct and indirect costs of the investment. present discounted value of only the direct costs of the investment. present discounted value of only the indirect costs of the investment.

Uncertainty, Entrepreneurship, and Profit

Determining future costs and benefits is not as easy as sticking numbers into a formula The formula is certainly helpful, but often the future costs and benefits are hard to estimate An entrepreneur is someone who takes risk on those future costs and benefits That risk taking is a major source of economic growth

Question Answers: 14.1 = 3 14.2 = 1 14.3 = 1