Module 8

Firms, the Stock Market, and

Corporate Governance
Sal2apao/[Link]

Spinning wind into energy

Wind farms are springing up across America. A
single turbine can generate enough electricity for
thousands of households. But a single turbine
costs millions of dollars—a massive investment!

Owners will only invest in wind if it’s profitable:

 Are the large up-front costs worth it to
generate a stream of future profits?

In this chapter you’ll explore the

framework that executives use to
evaluate investment decisions,
whose consequences play out over
time.
2 Macmillan Learning, ©2023
Key Definition Diving into the Definition
Macroeconomics investment examples:
Investment has a formal definition within Purchases of new…
macroeconomics, but is often used more loosely  business equipment
in casual conversation.
 offices and factories
 Both have to do with incurring some up-front  research and development for new software
costs today in the hope of receiving future
Colloquial meaning of investment:
benefits.
Conversationally, you might say you are investing in...
Investment: purchases of new capital, which  a new suit for a job interview
increase the economy’s productive capacity.  your education
 your personal brand
 Capital: assets such as equipment, structures,  These investments do NOT involve purchasing
and intellectual property that are used new capital assets like machines.
repeatedly to produce output.
 Doesn’t count as macroeconomic
investment.
3 Macmillan Learning, ©2023
 Investment and GDP
Investment is about one-sixth of Gross Domestic Product. Macroeconomic investment (the formal
definition) is the capital “I” in the definition of GDP:

Y = C + I + G + NX

Investment spending accounts for one-sixth of

GDP.

Helpful Hint:
Don’t confuse saving with investment.
 Putting your money in the bank, in a stock
portfolio, or using it to buy collectibles like art
or limited-edition sneakers is NOT investment.
 You’re not buying new capital.

4 Macmillan Learning, ©2023

 Macroeconomic investment

Trading an existing asset does not count as Investment adds to the capital stock;
investment. depreciation subtracts from it.
 Macroeconomic investment expands the  Capital stock: the total quantity of capital
economy’s productive capacity. at a point in time.
 Trading existing assets simply re-shuffles Investment is the flow of new purchases of
who owns what: capital that add to this stock.
 Buying shares in Amazon  Depreciation: the decline in capital due
 Buying a vintage car to wear and tear, obsolescence,
accidental damage, and aging.
 Buying Bitcoin or other financial assets
Capital stock declines when depreciation
NOT investment! exceeds investment.
5 Macmillan Learning, ©2023
 Types of investment (2 of 2)

1. Business investment

2. Housing investment

3. Inventories

7 Macmillan Learning, ©2023

 Investment type 1: Business investment

Business investment: the money that businesses spend on new capital assets.
 Equipment: new computers, machines, company cars, etc.
 Structures: new offices, stores, factories, remodeling of existing facilities, etc.
 Intellectual property: software, research and development, spending on
literary, television, movie and music production, etc.

Businesses are purchasing new capital that they will use to produce future output.
 Accounts for the bulk of investment in the economy.

8 Macmillan Learning, ©2023

 Buying a fixer-upper doesn’t
Investment type 2: Housing investment count as investment—but
spending on renovations does!
Housing investment: the money spent on building or
improving houses or apartments.
 Building a new home counts as macroeconomic
investment because it increases the economy’s
capacity to generate rent.
 Opportunity cost principle: your home could
be used to generate rental income.
 Helpful Hint: Existing homes don’t count as
macroeconomic investment because they don’t
create any new capital.
 Simply a transfer of ownership.
9 Macmillan Learning, ©2023
 Investment type 3: Inventories

Businesses also invest by maintaining inventories of raw materials, work-in-

progress, and unsold goods.
 Example: The cars you can test-drive at your local car dealership are counted
as inventories.
 An increase in inventories is counted as investment.
 Tiny share of total investment
 Volatile

10 Macmillan Learning, ©2023

 Investment drives the business cycle
Investment fluctuates dramatically as business
conditions change:
Possible impact of recession:
 GDP declines 2%
 Investment declines 20%

Investment is sensitive to…

 Future expectations
 Interest rates
 Lending standards

Once you figure out what drives investment,

you’ve figured out much of what drives the
business cycle
11 Macmillan Learning, ©2023
 Investment is a key driver of long-term prosperity

Countries with more capital per

worker produce more output per
worker.

12 Macmillan Learning, ©2023

 Key take-aways: What is investment?

Investment: Spending on new capital assets that increase the

economy’s productive capacity.
 Types of investment: Business investment, housing investment,
change in inventories.

Capital stock: the total quantity of capital at a point in time.

 Investment is the flow of new purchases of capital that add to this
stock.
 Declines over time due to depreciation (i.e., wear and tear).

13 Macmillan Learning, ©2023

 Evaluating investment decisions

Key trade-off: up-front costs and future benefits.

Goal: figure out how to value today’s costs relative to future benefits.
 Compare values at different points in time.
 Two analytical tools: compounding and discounting.

We will focus on evaluating business investments, but you can use these tools to analyze…
 your educational investments
 whether to buy a house
 whether to go to the gym
14 Macmillan Learning, ©2023
 Key Definition (1 of 4) Diving into the Definition
What’s the opportunity cost of pursuing an Example: What happens when you put
investment project? $100 in the bank if the interest rate is 3%?
 Forgone interest  A year later, you’ll get $100 back plus $3 in
interest:
 How much would your money grow
if you put it in the bank and left it to  $100 + $3 = $103
accumulate over time? What happens if you leave that money in the
bank for another year?
Compounding: the accumulation of
money over time, as you earn interest on  A year later, you’ll get $103 back plus
$3.09 in interest:
both your principal and accrued interest.
 Calculates how much money grows  $103 + $3.09 = $106.09
over time when you leave it to Let’s discuss the magic of compound interest!
15 accumulate interest. Macmillan Learning, ©2023
 Investment Tool 1: Compounding
The magic of compound interest!
 You earn interest not only on your initial deposit but also on previously earned
interest, so your wealth compounds!

Future value in one year = Present value + r × Present value

You get your money back Plus r % interest

_______________= Present value × (1 + r )

Future value: the amount that our money will grow into by a specific future date, as a
result of accumulating interest.
 Each year you leave your money in the bank, it’s multiplied by 1 + r

16 Macmillan Learning, ©2023

 © Worth Publishers
The magic of compound interest After t years, your money has
grown to be worth: Future value =
Present value × (1 + r )t
Each year your money earns interest
and grows to be ( 1 + r ) times larger.

Begin with an initial deposit of $P,

called the present value.
17 Macmillan Learning, ©2023
 The compounding interest formula

The magic of compound interest!

 You earn interest not only on your initial deposit but also on previously earned
interest, so your wealth compounds over the years:

Future value in t years = Present value × (1 + r)t

Example: What would happen if you invested $16,000 for 20 years in a stock portfolio,
where you expect the value of your investment to rise by 5% each year?
 Future value = $16,000 × (1 + 0.05)20 = $42,452.76

18 Macmillan Learning, ©2023

 Compounding: Let a spreadsheet do the work for you!

19 Macmillan Learning, ©2023

 The extraordinary power of
compound interest
Jonathan Holdeen was a rich New York lawyer, a very frugal
person, and obsessed with compound interest.
To Holdeen, every penny waved was a thousand trillion dollars
gained:
 $0.01 × (1 + 0.04)1,000 ≈ $1,000,000,000,000,000.

Holdeen’s plan: Put millions into a charitable trust and let it compound for 1,000 years.
 Hopefully enough money to abolish all taxes in Pennsylvania!
Instead, he set off a 50-year legal battle!  What’s the impact of a trust that big?!
 Courts decided the trust had to donate each year’s interest payments to charity.
 Stopped the trust from growing.
20 Macmillan Learning, ©2023
 Key Definition (2 of 4) Diving into the Definition
How much are future costs or benefits Present value: The amount of money
worth today? that you would need to invest today in
 Forgone opportunity to gain from order to produce a specific benefit in the
future.
compounding interest.
 Receiving $100 in the future is not How much money would you need to put in
the same as $100 today, because if I the bank today in order for it to grow into
got $100 today, then I could earn that sum in the future?
interest during this upcoming year.  Discounting converts larger future
values into the smaller present values
Discounting: Converting future values from which they could have grown.
into their equivalent present values.

21 Macmillan Learning, ©2023

 Investment Tool 2: Discounting

Take the compounding formula and rearrange it to get the discounting formula:
 Compounding formula:
Future value in t years = Present value × ( 1 + r)t

 Discounting formula:
Present value = Future value in t years ÷ ( 1 + r)t
The discounting formula converts potential future values into their equivalent present values.

22 Macmillan Learning, ©2023

 © Worth Publishers
Compounding and Discounting

23 Macmillan Learning, ©2023

 Concept check: The discounting formula

Question: What’s the present value of receiving $20,000 in 5 years,

if the interest rate is 3% per year?
Solution: The present value is $17,252.18.
Present value = Future value in t years ÷ ( 1 + r)t
Present value = $20,000 ÷ ( 1 + 0.3)5 = $17,252.18

24 Macmillan Learning, ©2023

 Discounting: Let a spreadsheet do the work for you!

25 Macmillan Learning, ©2023

 Real versus nominal interest rates

RECALL:
Nominal values refer to the number of dollars you have.
 To assess the nominal value of your funds, use the nominal interest rate in the
compounding or discounting formula.

Real values adjust for inflation.

 To assess the real value of your funds, use the real interest rate in the
compounding or discounting formula.
 This focuses on your purchasing power.

26 Macmillan Learning, ©2023

 You Try! Compare real and nominal future values (2 of 2)

Stock market scenario: Over the past century, a) Nominal future value in 100 years
money in the stock market grew at an average
= $5,000 × (1 + 0.1085)100
rate of 10.85% per year.
= $148,778,353.92_________
If you put $5,000 in the stock market in 1922,
how much would it have compounded into by
2022? b) Real future value in 100 years
a) Calculate the nominal future value. Adjust 10.85% for 3% inflation:

b) Calculate the real future value if the  10.85% − 3% = 7.85%

inflation rate was 3% per year.  Stock market grew by 7.85% in real terms.
= $5,000 × (1 + 0.0785)100
= $9,571,608.97_____________

28 Macmillan Learning, ©2023

 Key take-aways: Tools to analyze investments

Compounding: Helps you calculate how money grows over time when you
leave it to accumulate interest in the bank.
 Future value in t years = Present value × (1 + r)t

Discounting: used to figure out how much future money is worth today.
 Present value = Future value in t years ÷ (1 + r)t

Interest rate (r ): The interest rate you use in the compounding or discounting
formula should be the rate of return you could get from investing your funds
in your next best alternative.

29 Macmillan Learning, ©2023

 Evaluating an investment opportunity

Four-step recipe: The Scenario:

1. Calculate the up-front cost. You work for a renewable energy company
that currently operates eight wind turbines,
2. Predict future profits, taking
account of depreciation. which powers nearly 10,000 homes.
3. Calculate the present value of all The company CEO is trying to decide
benefits and costs. whether to invest in one more turbine.
 Shortcut: valuation formula Your task: Figure out if this is a worthwhile
4. Invest if the present value of investment.
benefits exceeds the present
value of costs.

30 Macmillan Learning, ©2023

 Four-step recipe (1 of 4)
STEP 1: Investing in a new turbine requires
Four-step recipe: an up-front investment of $4 million.
1. Calculate the up-front cost.
2. Predict future profits, taking STEP 2: Calculate the future annual profits
account of depreciation. this turbine will generate.
3. Calculate the present value of all  This year: no profit.
benefits and costs.
 First year profit: $600,000.
 Shortcut: valuation formula.
 Profit in following years: less
4. Invest if the present value of productive due to depreciation.
benefits exceeds the present
value of costs.  4% less output each year.
 $600,000 down to $576,000 in the
second year, then down to $552,960
31 in the third year, etc. Macmillan Learning, ©2023
 Step 2: the stream of future profits

After the first year, the profit of each

subsequent year will be 4% less due to
depreciation (d ).

Future Revenue
= Last year’s revenue × ( 1 − d )

32 Macmillan Learning, ©2023

 Four-step recipe (2 of 4)
Four-step recipe: STEP 3: Convert all benefits and costs into their
present values so that we can compare them.
1. Calculate the up-front cost.
 Note that costs are already in present value!
2. Predict future profits, taking
account of depreciation.  Calculate the present value of your future
profit stream.
3. Calculate the present value of
all benefits and costs. Suppose there is a 6% interest rate. Then…
 Shortcut: valuation formula.  Present value of first year’s profit:
4. Invest if the present value of = $600,000 ÷ (1 + 0.06)
benefits exceeds the present
value of costs. = $566,038
 Present value of second year’s profit…

33 Macmillan Learning, ©2023

 Step 3: the present value of the stream of future profits

Add up the present value

of these future years of
profits (until the turbine
fully depreciates).
 $6 million

34 Macmillan Learning, ©2023

 Four-step recipe (3 of 4)
STEP 3 Shortcut: the valuation formula
Four-step recipe:
The valuation formula tells you how much
1. Calculate the up-front cost. you would value this future stream of
2. Predict future profits, taking profits in today’s dollars.
account of depreciation.
3. Calculate the present value of Present value of a stream of payments
all benefits and costs.
Next year's profit
 Shortcut: valuation formula. =
r +d
4. Invest if the present value of
benefits exceeds the present Present value of our profit stream
value of costs.
$600,000
= = $6 million
0.06 + 0.04
35 Macmillan Learning, ©2023
 Four-step recipe (4 of 4)
STEP 4: Do the benefits exceed the costs?
Four-step recipe:
1. Calculate the up-front cost.
Present value benefits: $6 million.
2. Predict future profits, taking
Present value costs: $4 million.
account of depreciation.
3. Calculate the present value of all
benefits and costs. Yes, invest in the ninth turbine!
 Shortcut: valuation formula.  This project boosts your profits by
$2 million!
4. Invest if the present value of
benefits exceeds the present  Also boosts your profits by more
value of costs. than investing your funds in your
next best alternative.

36 Macmillan Learning, ©2023

 The rational rule for investors

Rational rule for investors: Pursue an investment opportunity if the present value of
future profits is greater than (or perhaps equal to) the up-front costs, C.
This means you should invest when: Next year's profit ≥ C
r +d

Present value of Up-front

future profits cost

Leads you to invest only when it will boost your long-run profitability!

37 Macmillan Learning, ©2023

 An alternative perspective: The user cost of capital (1 of 2)

Instead of asking, “Should I buy this one machine that I will keep for many decades?”
You could ask, “Should I buy one more machine for one more year?”
 Maybe you are thinking about selling it in a year’s time.
 Or maybe you are considering renting a machine for a year.

Apply the cost-benefit principle:

 Do the marginal benefits exceed the marginal costs of using that extra machine for one
more year?

Let’s explore this perspective more deeply!

38 Macmillan Learning, ©2023

 Assessing the marginal benefit and marginal cost

Marginal benefit: next year’s profit.

 That extra machine will generate extra output, and hence, profit.

Marginal cost: Consider both depreciation and forgone interest.

 Depreciation: When you buy capital equipment and sell it a year later, it will be worth less
because of wear and tear.
 Expected loss due to deprecation = d × C
 Forgone interest: When you buy capital equipment, you’re tying up your funds for a year.
 You could have earned 6% return (or some other amount) on those funds!
 Expected loss due to forgone interest = r × C
39 Macmillan Learning, ©2023
 Key Definition (3 of 4) Diving into the Definition

Putting all marginal cost pieces together! Wind turbine example revisited:

User cost of capital: the extra cost  Forgone interest: The real interest rate
associated with using one more machine is 6% per year.
next year.  Depreciation: A $4 million wind turbine
will be worth 4% less at the end of the
 Sometimes called the rental cost.
year.
The user cost of capital is forgone interest
plus depreciation: User cost of capital = (r + d ) × C
= (0.06 + 0.4) × $4 million
User cost of capital = (r + d ) × C = $400,000

40 Macmillan Learning, ©2023

 An alternative perspective: The user cost of capital (2 of 2)

“Should I buy one more machine for one more year?”

Apply the cost-benefit principle:
 Do the marginal benefits exceed the marginal costs of using that extra machine for
one more year?

Recapping the wind turbine example:

 Marginal benefits = next year’s profit = $600,000
 Marginal costs = user cost of capital = $400,000
 Conclusion: Yes, invest in buying the wind turbine!

41 Macmillan Learning, ©2023

 Reisegraf/iStock/Getty Images

The true cost of car ownership

When thinking about the annual cost of owning a car, don’t
just focus on the out-of-pocket costs like gas and
insurance. Remember to consider the user cost of capital!
Cars depreciate rapidly—around 15% each year!

If you spent $10,000 to buy the car, then you won’t earn
any interest on that money.
 Suppose real interest rate is 3%.
User cost of capital = (r + d ) × C
= (0.03 + 0.15) × $10,000
= $1,800
If you didn’t own the car, then you would be $1,800
wealthier at the end of the year.

42 Macmillan Learning, ©2023

 © Worth Publishers
It’s all the same rational rule for investors!

43 Macmillan Learning, ©2023

 Key take-aways: Making investment decisions

Interest rate (r ): the rate of return you could get from investing your funds in
your next best alternative.
depreciation rate (d ): the proportion of an investment’s remaining productive
capacity you lose each year due to depreciation.

44 Macmillan Learning, ©2023

 Scaling up to a macro perspective

Total investment in the economy = sum of all individual investments.

The rational rule for investors focuses our attention on key macroeconomic variables
that will determine investment:
Next year's profit
≥ C
r +d

Investment will depend on…

 Expectations about future profits  Depreciation rate, d
 Real interest rate, r  Real cost of capital, C

45 Macmillan Learning, ©2023

 The real interest rate and Revisiting the turbine example
investment Calculating the present value of future profits
with three real interest rates:
Higher real interest rates lead managers
to invest less in buying new capital. 1. Originally, r = 6%
Yes, invest!
 Opportunity cost principle: “Or what?” $600,000 $6m > $4m
= = $6 million
0.06 + 0.04
 Manager’s next best alternative is
often leaving their money in the bank
2. Now consider r = 8% Yes, invest!
to earn interest.
$600,000 $5m > $4m
 High interest rates mean higher = = $5 million
0.08 + 0.04
opportunity cost.
3. Finally consider r = 12%
 Smaller chance the investment $600,000
Don’t invest!
project will pass the cost-benefit = = $3.75 million $3.75m < $4m
0.12 + 0.04
test.
46 Macmillan Learning, ©2023
 Investment declines as the real interest rate rises

Real interest rate The higher the real interest rate, the lower
the present value of future profits.
 Fewer investments will pass the cost-
High real A benefit test.
interest rate
A change in real interest rates causes a
movement along the investment line.
B
Low real A A higher real interest rate leads to low
interest rate Investment
line investment.

Total B A lower real interest rate leads to high

Low High investment investment.
investment investment

47 Macmillan Learning, ©2023

 What will shift the investment line?

Favorable changes in business conditions will lead

to an increase in investment if it:
Real interest rate
 Increases expectations of future profits
 Decreases the price of capital goods
 Reduces the depreciation rate Increased
investment
Any change in business conditions that makes
investment more profitable will…
 Increase in investment (rightward shift).
Investment
Any change in business conditions that makes Decreased investment
investment less profitable will…
 decrease in investment (leftward shift). Total investment

Macmillan Learning, ©2023

 Four investment shifters (1 of 4)
Technological advances…
Four investment shifters:
 Make capital equipment more productive.
1. Technological advances  Boosts profits!
 Makes the investment more attractive at any
2. Expectations
given interest rate.
3. Corporate taxes Technological advances…
 Reduce the depreciation rate.
4. Lending standards and
cash reserves  Boosts future output and profits!
 Makes the investment more attractive at any
…but not a change in real given interest rate.
interest rates.
Hence, technological advances shift the investment line
to the right.
49 Macmillan Learning, ©2023
 Four investment shifters (2 of 4)
Four investment shifters: Expectations:
1. Technological advances If managers are optimistic about future economics
conditions…
2. Expectations  they forecast that new investments are likely to yield
robust profits.
3. Corporate taxes  Invest more (investment line shifts right)

4. Lending standards and If managers are pessimistic about future economics

cash reserves conditions…
 they invest less (investment line shifts left).
…but not a change in real
interest rates.

50 Macmillan Learning, ©2023

 Expectations of higher earning lead to increased investment.

51 Macmillan Learning, ©2023

 Four investment shifters (3 of 4)
Four investment shifters: Corporate taxes: High corporate tax rates mean
1. Technological advances the company keeps a smaller share of future profits.
 Reduces the profits you’ll get to keep from any
2. Expectations investment.
 Invest less (investment line shifts left).
3. Corporate taxes
The wind industry has benefited from tax breaks.
4. Lending standards and  Tax breaks increase revenue, and hence, profits
cash reserves from each turbine.
 Invest more (investment line shifts right).
…but not a change in real
interest rates.

52 Macmillan Learning, ©2023

 Four investment shifters (4 of 4)
Four investment shifters: Lending standards and cash reserves:
Investment challenge: How will you finance your new
1. Technological advances
investment?
2. Expectations  How will you get the up-front cash to pay for your
new capital?
3. Corporate taxes  Borrow the funds from a bank.
 Use your company’s cash reserves.
4. Lending standards and
cash reserves More investment when…
 companies face less restrictive lending standards
…but not a change in real
interest rates.  or when they have enough cash reserves.

53 Macmillan Learning, ©2023

 Key take-aways: The macroeconomics of investment

A change in real interest rates will A change in business conditions that

cause a movement along the change the profitability of investment will
investment line. cause the investment line to shift.

54 Macmillan Learning, ©2023

 Forecasting the long-run real interest rate

So far...
 We have taken the real interest rate as given.
Now…
 Dig into the factors that shape the real interest rate.
Focus on long-run real interest rate, not short run:
 Long-run real interest rate evolves slowly over many years in response to the balance
of saving and investment.
 Short-run real interest rate rises and falls each month with adjustments from the
Federal Reserve.

55 Macmillan Learning, ©2023

Key Definition (4 of 4) Diving into the Definition

The market for loanable funds Savers are the suppliers.

determines the long-run real interest rate,  They supply their funds to businesses who
and, therefore, the quantity of investment. want to borrow them.
Investors are the demanders.
Market for loanable funds: The  They demand funds to help fund their
market for the funds used to buy, rent, or investments in new capital.
build capital.
The financial sector is the marketplace.
 Brings together savers who want to lend  Banks, the bond market, and stock markets
their funds, and investors who want to are where suppliers meet demanders.
borrow those funds. The real interest rate is the price of a loan.
Let’s look at the features of this market!  The amount the borrower must pay a
lender to borrow $100 for a year.
56 Macmillan Learning, ©2023
 The market for loanable funds
The supply curve is upward-sloping: Price of loanable funds
 A higher real interest rate raises the benefits = Real interest rate
of savings. Supply
(from saving)
The demand curve is downward-sloping:
 A higher real interest rate makes fewer
investment projects profitable.
Neutral real
Equilibrium occurs where the curves cross: interest rate
Equilibrium
 This determines the equilibrium real interest
rate.
Neutral real interest rate: the interest rate that Demand
operates when the economy is in neutral – (from investment)
producing neither above nor below its potential.
Quantity of loanable funds ($)
57 Macmillan Learning, ©2023
 Shifting the supply of loanable funds

A decrease in saving shifts the supply of Real interest rate

loanable funds to the left… Decreased saving
Initial supply
 higher real interest rate. (Saving)

An increase in saving shifts the supply of

3.5% Increased
loanable funds to the right… saving
 Lower real interest rate. 3.0%

There are three economic actors whose 3.5%

change in savings will impact the supply of
loanable funds:
Demand
1. Private savers
(investment)
2. The government
3. Foreigners
Quantity of loanable funds

58 Macmillan Learning, ©2023

 Supply shifter 1: Changes in personal saving rates

Personal saving refers to saving by Pandemic example: People stayed home and cut
households of whatever income they don’t back spending, and the government sent out checks.
The result was an increase in savings, which shifted
spend of pay as taxes.
the supply of loanable funds to the right.
 putting money in the bank.
Real interest
 paying down your debt. rate Initial supply Increased
savings
 Frees up loanable funds for others to use.

Anything that shifts people’s willingness to Demand

save will shift the supply of loanable funds. (investment)

Quantity
of loanable funds
59 Macmillan Learning, ©2023
 Supply shifter 2: Government saving shifts due to changing budget
surpluses and deficits
Government saving refers to saving by the government.

Budget surplus: when government Budget deficit: when the government

revenues exceed outlays. spends more than it takes in.
The government borrows by issuing bonds,
These extra government funds are which people and businesses buy with their
typically used to repay government savings.
debt, which frees up those funds for  Less savings leads to a decrease in the
others to borrow. supply of loanable funds.
 Increases the supply of loanable  Thus, a government deficit decreases
funds available (rightward shift). the supply of loanable funds available
(leftward shift).
60 Macmillan Learning, ©2023
 Real interest Decreased
Exploring Supply shifter 2 savings
rate
Initial supply

Budget deficit and crowding out.

 Crowding out: The decline in private
spending—and particularly Demand
investment—that follows from a rise (investment)
in government borrowing.
The higher real interest rates effectively Quantity
crowd out some of the firms looking for of loanable funds
loans to fund their own investments. Real interest
rate Initial supply Increased
Budget surplus example: savings
President Bill Clinton pushed the federal
budget from a large deficit into a modest
surplus. Demand
 Result: decline in long-run real (investment)
interest rates, which spurred more
private investment.
Quantity
of loanable funds
61 Macmillan Learning, ©2023
 Supply shifter 3: Foreign saving shifts due to global shocks

Foreign savings (or net financial inflows) is the funding that comes from foreigners lending
money to Americans.

Example:
In the early 2000s, an increase in saving in the rapidly growing Asian countries and oil-producing
Middle East increased global savings.
 Much of this saving was lent to American companies.
 Rise in foreign saving shifted the supply of loanable funds to the right.
 Pushed down the neutral real interest rate.

62 Macmillan Learning, ©2023

 Shifting the demand of loanable funds

An increase in investment shifts the demand Real interest rate

for loanable funds to the right… Initial supply
 higher real interest rate. (Saving)

A decrease in investment shifts the demand

for loanable funds to the left… 4% Increased
 lower real interest rate. investment
3%
Any factor that shifts the investment line will
also shift the demand for loanable funds: 2%
Initial demand
1. Technological advances (investment)
2. Expectations
Decreased investment
3. Corporate tax cuts
4. Easier lending standards + larger cash
reserves Quantity of loanable funds

63 Macmillan Learning, ©2023

 Secular stagnation and the case
of the declining real interest rate

There has been a long-term decrease in the

demand for loanable funds as the structure
of the economy has changed.

1. Slowing population growth

2. The rise of technology firms

3. Cheaper capital equipment

64 Macmillan Learning, ©2023

 Scenario: As more students go to college, an
You Try! Example 1 (2 of 2)
increasing share of parents open college
savings accounts.
Step 1: Does this shift supply or demand?
Real interest
 The supply of loanable fund shifts. rate Supply
Step 2: Leftward or rightward shift? Increased
 More people putting away more Supply
money means private savings will rise.
rold
 Increased supply of funds shifts right.
rnew
(shifter: personal saving rates)
Demand
Step 3: Assess equilibrium outcomes.
 Lower real interest rates.
Q0ld Qnew Quantity
 More saving and investment. ofMacmillan
loanable funds
66 Learning, ©2023
 Scenario: Business executives expect their
You Try! Example 2 (2 of 2)
profit margins to decline over the next decade.

Step 1: Does this shift supply or demand? Real interest

rate Supply
 The demand for loanable fund shifts.

Step 2: Leftward or rightward shift? rold

 Lower future profits will reduce
investment (shift left). rnew
(shifter: expectations) Demand
Step 3: Assess equilibrium outcomes. Decreased
 Lower real interest rates. Demand

 Less saving and investment. Qnew Q0ld Quantity

of loanable funds
68 Macmillan Learning, ©2023
 Key take-aways: The market for loanable funds

Market for loanable funds: The market for the funds used to buy, rent, or
build capital.

Supply shifters: changes in personal

saving rates, government saving, or
foreign saving.

Demand shifters: technological

advances, expectations, corporate taxes,
or lending standards and cash reserves.

69 Macmillan Learning, ©2023

 Function of Financial Markets (1 of 2)
• Performs the essential function of channeling funds from economic
players that have saved surplus funds to those that have a shortage of
funds
• Direct finance: borrowers borrow funds directly from lenders in financial
markets by selling them securities

Macmillan Learning, ©2023

 Function of Financial Markets (2 of 2)
• Promotes economic efficiency by producing an efficient allocation of
capital, which increases production
• Directly improve the well-being of consumers by allowing them to time
purchases better

Macmillan Learning, ©2023

Figure 1 Flows of Funds Through the Financial
System

Macmillan Learning, ©2023

 Wang Ying/Xinhua/Alamy

The Financial Sector

The financial sector touches every
aspect of your life:
 Student loans
 Auto loans
 Purchases with credit cards
 Your savings in the stock market
 The roads you drive on!
We will explore the three key pillars
of the financial sector:
1. Banks
2. The bond market
3. The stock market
73 Macmillan Learning, ©2023
 What Do Banks Do?

Banks do not simply store your money for you.

 Rather, they are borrowing money from you!
 Take your money and puts it to work by lending it out.
 Student loans; home loans; funding for companies like Nike or Coca-Cola.

How do banks make money?  by charging higher interest rates than they pay.
 Banks as borrowers: pays you interest on your deposit.
 Banks as lenders: lends your deposit out to someone else at a higher interest rate.
 Example: bank pays 2% interest on deposits, and receives 6% interest on loans,
which means the bank gets 4%!
74 Macmillan Learning, ©2023
 What banks do (1 of 2)
Function 1: Banks pool savings from many savers.
What banks do:
 Easier for borrowers to go to one bank than to
1. Pool savings from many savers try and borrow from many individuals.

2. Spread the risk of lending Function 2: Spread the risk of lending.

money across many borrowers  The bank does not lend all your savings to one
borrower.
3. Solve information problems  Rather, it lends to a diverse array of borrowers.
4. Provide payment services  More diverse portfolio = less risky loans.

Function 3: Solve information problems.

5. Create long-term loans from
short-term deposits  Only lends to borrowers after investigating their
financial history.
 Identify which borrowers can repay their loans.
75 Macmillan Learning, ©2023
 What banks do (2 of 2)
Function 4: Provide payment services.
What banks do:
 A bank’s payment services are often more
1. Pool savings from many savers convenient than using cash.
 Paycheck direct deposit; pay bills online;
2. Spread the risk of lending send money overseas via bank transfer;
money across many borrowers shop online using credit card.

3. Solve information problems Function 5: Long-term loans from short-term

deposits.
4. Provide payment services  Maturity transformation: using short-term loans
to make long-term loans.
5. Create long-term loans from  Source of tension and potential risk.
short-term deposits  Savers expect they can withdraw their fund
whenever they want, but borrowers repay
76 over a longer period of time. Macmillan Learning, ©2023
Key Definition (1 of 4) Diving into the Definition
If banks lend your money out to others, then Banks can handle a typical day with a typical
how do you know your money will be at the level of withdrawals, but if the day is not
bank when you want it? typical then…
 You don’t!  Bank runs can cause a bank to collapse.
 Banks keep just enough cash on hand to
meet a typical level of withdrawals, plus a What makes a day typical?
bit extra.  A day is typical if most people believe that
it is a typical day.
Bank run: when many bank customers try
to withdraw their savings at the same time.  If you believe that the day is NOT typical,
 The bank might not have enough money then your best response is to RUN to the
on hand to give you your money when bank and withdraw your savings before
you ask for it. others and the bank runs out of money.
77 Macmillan Learning, ©2023
 Anything can trigger a The toilet paper panic of
bank run 2020 was like a bank run
Fear of a run on toilet paper (like a run on
A bank run is likely whenever people believe a
bank run is likely. banks) can be a self-fulfilling prophecy.
False rumors on Twitter:  Even people who weren’t worried
 10,000 Latvians rushed to withdraw upon about being locked down during the
hearing a false rumor that Swedish- pandemic started to worry they’d be
owned banks were planning on shutting
down operations in Latvia. left without toilet paper.
Run to withdraw even if you know the rumor  Result: Everyone bought more than
is untrue. usual because they feared being left
 Interference principle: Your best choice with none.
depends on what others will do, and vice
versa.
 Self-fulfilling panic.

78 Macmillan Learning, ©2023

 Bank runs can be contagious

2008 Example:
On September 15, 2008, Lehman Brothers collapsed.
 This increased concern about Washington Mutual.
 Within 10 days, customers withdrew $16.7 billion.
 Washington Mutual collapsed on Sept. 25th.
 This increased concern about Wachovia Bank.
 Forced into a fire sale in which they sold themselves to Wells Fargo to meet
depositors’ demands.

79 Macmillan Learning, ©2023

 Deposit insurance makes bank runs much less likely

Early 1930s: Over one-third of all

existing banks failed.
 In response, government introduced
deposit insurance.
Deposit insurance: a guarantee that
you won’t lose the money you deposit in
the bank.
 Covers up to $250,000 per account.
 Breaks the interdependence that
leads to self-fulfilling panics.

80 Macmillan Learning, ©2023

 Key Definition (2 of 4) Diving into the Definition

Shadow banks: Financial firms that act like Shadow bank examples:
banks but, since they are not actually banks, Investment banks (JP Morgan Chase,
do not have to follow the same rules as Goldman Sachs), insurance companies,
banks. payday lenders, private equity firms,
mortgage lenders.
 Take funds from investors and use these
funds to make longer-term investments.
Still susceptible to bank runs:
 Maturity transformation!
 Bear Sterns was an investment bank
 Engaged in activities that involve greater that failed in 2008.
risk (but higher potential returns).  When investors lost faith, they
 No deposit insurance. withdrew their money.

81 Macmillan Learning, ©2023

 Shadow banks are opaque

Unknown interdependencies can make small problems balloon into big ones.
 Like knowing a small share of the meat supply is infected, but not knowing which
shipments are affected  millions of people stop eating meat.
 If you don’t know which shadow banks are infected with bad loans (and there’s no
deposit insurance), then you won’t lend to any of them.
 A small number of bad loans in 2008 brought a sharp decline in lending, which
sparked a major recession.
 Now, post-2008, there is greater regulation of shadow banks.

82 Macmillan Learning, ©2023

 Key take-aways: Banks
A bank borrows money from savers and lends it out in an effort to
earn itself a profit.
 Savings are lent out to multiple borrowers.
 Solve information problems and provide payment services.
 Savers can withdraw their savings any time. Borrowers get
longer-term loans.
 One big risk: Bank runs.
Shadow banks are financial firms that are similar to banks, but are
not regulated like banks.

83 Macmillan Learning, ©2023

 Key Definition (3 of 4) Diving into the Definition
Suppose you’re Nike, looking to borrow $1 billion to fund The bond records…
a new investment.
 Issuer: the borrower
 Most banks aren’t prepared to deal with a loan that
big.  If Nike issued a bond to fund their $1
The bond market is where the big dogs go to borrow the billion investment, then Nike is the issuer.
big bucks.
 Principle: the amount to be repaid
 Big source of corporate financing.
 For Nike, $1 billion.
 In 2021, $2 trillion from issuing bonds, compared to
$450 billion by issuing new stock.  Maturity date: due date for repayment
Bond: an IOU. Specifically, a promise to pay back a loan  For Nike, March 27, 2027.
with interest.
 Coupons: interest paid along the way
 A piece of paper spelling out the terms of the IOU.
 Nike pays 2.75% interest per year.
84 Macmillan Learning, ©2023
 What the bond market does (1 of 2)

What the bond market does: Function 1: The bond market channels funds
from savers to borrowers.
1. Channel funds from savers  Provides an alternative to banks where
to borrowers companies can borrow large sums.

2. Funds government debt Function 2: The bond market funds

government debt.
3. Spreads risk
 The U.S. government borrows money by
4. Creates liquidity issuing bonds.
 The U.S. federal government is the biggest
player in the bond market.

85 Macmillan Learning, ©2023

 What the bond market does (2 of 2)
Function 3: The bond market spreads risk.
What the bond market does:
 Nike issues thousands of bonds, rather than
1. Channel funds from savers issuing one $1 billion bond to one person.
to borrowers
Function 4: The bond market creates liquidity.
2. Funds government debt  There are many buyers in the bond market, so
you can always resell the bond you bought from
3. Spreads risk Nike if you suddenly discover you need the cash
before the loan is due.
4. Creates liquidity
 Liquidity: the ability to quickly and easily convert
your investments into cash, with little or no loss
in value.
 Maturity transformation!
86 Macmillan Learning, ©2023
 The bond market: Evaluating risks (1 of 3)
Risk 1: Default risk is the risk of not getting paid.
Bond risks:
 What if Nike goes bust and they can’t repay you?!
1. Default risk
Companies like Fitch, Standard and Poor’s, and Moody’s
2. Term risk evaluate companies and assign credit ratings.
 Use these credit ratings to assess default risk.
3. Liquidity risk

Interest rates rise with default risk

AAA is the highest possible rating.

The company has an extremely
strong capacity to repay its debt.
87 Macmillan Learning, ©2023
 The bond market: Evaluating risks (2 of 3)
Risk 2: Term risk arises when there’s uncertainty about
Bond risks: future interest rates.
1. Default risk Tying up your money comes with an opportunity cost.

2. Term risk  You could put that money in the bank and earn interest
on it.
3. Liquidity risk. The longer the term of the loan, the more likely interest rates
will change, and so the higher the term risk:
 Example: You buy a bond which pays out 2.375% per
year for 20 years. If interest rates shoot up to 4%, then
you’re missing out on the opportunity to earn a bigger
return because your money is tied up in the bond.

88 Macmillan Learning, ©2023

 The bond market: Evaluating risks (3 of 3)
Risk 3: Liquidity risk arises when your bond will be hard to sell.
Bond risks:
There’s a risk that you won’t be able to quickly find a buyer for
1. Default risk your bonds during the time when you need those funds yourself.

2. Term risk  You may not get a good price for it!

3. Liquidity risk.

89 Macmillan Learning, ©2023

 U.S. government bonds

Treasuries: bonds issued by the U.S. government.

U.S. government bonds are the safest investment.
 The U.S. government can always repay its debt by simply printing more money.
 Political risk in Congress.
U.S. government bonds are the most heavily traded bonds in the world.
 $600 billion traded each day.
 Carry basically no liquidity risk.
 But low risk comes with lower reward (very low interest rate on Treasuries).

90 Macmillan Learning, ©2023

 Key take-aways: The bond market
A bond is an IOU. Specifically, a promise to pay back a loan with interest.
 The bond market is where companies and governments can borrow large
sums of money.
What they do:
 Reallocate resources from savers to borrowers.
 Fund government debt.
 Reallocate, spread, and reduce risk.
 Create liquidity.

Risks include default risk, term risk, and liquidity risk.

91 Macmillan Learning, ©2023

 Key Definition (4 of 4) Diving into the Definition
A company can also finance expansions or Nike stock example:
investment projects by raising money with
the sale of stock to the public. At the start of 2022, there were about
1,600,000,000 shares in Nike.
 Each share is worth about $150.

This means for $150 you can own

1/1,600,000,000 of Nike.
 As partial owner, you make money if
Stock: partial ownership in a firm.
Nike makes money, and you lose
 Stock is sometimes called a share.
money if Nike loses money.
 Owners of stock are called shareholders.
92 Macmillan Learning, ©2023
 A stock entitles you to a share of future profits

You benefit from the stock you own in two ways:

1. Dividends: A share of profits that a company pays to its shareholders.
 Over the course of the year, the dividend payments usually add up to a return equal
to the value of about 1% or 2% the value of the stock.

2. The value of your shares can rise.

 A company’s growing future profitability = higher value company = higher stock price
 The stock you own is now worth more!

93 Macmillan Learning, ©2023

 Nike’s stock goes swoosh

$1,000 in Nike stock in 1980 is worth

over $1,500,000 at the end of 2021!

94 Macmillan Learning, ©2023

 What stocks do (1 of 2)
Function 1: Stocks channel funds from savers to
What stocks do: investors.
1. Channel funds from  Companies primarily issue stock to raise money
savers to investors to fund investments.
 Initial public offering (IPO): when a company
2. Spread risk first sells stock directly to the public.

3. Reallocate control Function 2: Stocks spread risk.

 Shareholders gain when the company gains,
but do badly when the company does badly.
 Stocks spread the risk of business
performance across many shareholders,
reducing the risk any one person faces.

95 Macmillan Learning, ©2023

 What stocks do (2 of 2)
Function 3: Stocks reallocate control.
What stocks do:  As a shareholder, you get a say in how the
1. Channel funds from company is run.
savers to investors
Shareholders vote in shareholders meetings:
2. Spread risk  Elect the board of directors.
 Vote on major issues (mergers, senior
3. Reallocate control
management wages).
 Get to ask questions at annual meetings.

96 Macmillan Learning, ©2023

 The stock market creates liquidity

The stock market is a market for second-hand stock.

 Stock market: the market people buy and sell existing stocks.

Funds used to buy stock in the stock market do NOT go to the company.
 You’re buying from an existing shareholder.
 Nike gets nothing when you buy a pre-owned stock.

Main role of stock market:

 Creates liquidity that encourages people to invest in companies.

97 Macmillan Learning, ©2023

 Comparing bonds and stocks

98 Macmillan Learning, ©2023

 An example:
Nike

99 Macmillan Learning, ©2023

 Key take-aways: The stock market
A stock represents partial ownership in a firm that may pay uncertain
future dividends.
The stock market is the market where people buy and sell existing
stocks.
What stocks do:
 A saver buys shares in a company, funding that company’s
investment.
 Shareholders can sell their stock. The investment remains with the
company forever.
 Stocks reallocate control and spreads risk.

10
Macmillan Learning, ©2023