Chapter 14

1. What Is Investment?
2. Tools to Analyze Investments

Investment 3. Making Investment Decisions

4. The Macroeconomics of
Investment
5. The Market for Loanable
Funds

Macmillan Learning, ©2023

Chapter 14
Learn what 1. What Is Investment?
macroeconomists
mean by investment, 2. Tools to Analyze Investments
and assess the role it
plays in the economy: 3. Making Investment Decisions
 Defining investment 4. The Macroeconomics of
 Types of investment Investment
5. The Market for Loanable
Funds

Macmillan Learning, ©2023

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.

3 Macmillan Learning, ©2023

Key Definition Diving into the
Definition
Macroeconomics investment examples:
Investment has a formal definition Purchases of new…
within macroeconomics, but is often  business equipment
used more loosely in casual  offices and factories
conversation.  research and development for new
 Both have to do with incurring some software
up-front costs today in the hope of Colloquial meaning of investment:
receiving future benefits. Conversationally, you might say you are
investing in...
Investment: purchases of new  a new suit for a job interview
capital, which increase the  your education
economy’s productive capacity.  your personal brand
 These investments do NOT involve
 Capital: assets such as equipment, purchasing new capital assets like
structures, and intellectual property machines.
that are used repeatedly to produce  Doesn’t count as macroeconomic
4
output. investment. 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.
5 Macmillan Learning, ©2023
 Macroeconomic investment

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

1. Business
investment

2. Housing
investment

3. Inventories

8 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.
9 Macmillan Learning, ©2023
 Investment type 2: Housing Buying a fixer-upper
doesn’t count as
investment
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.
10 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

11 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
12
of what drives the business cycle Macmillan Learning, ©2023
 Investment is a key driver of long-term prosperity

Countries with more capital

per worker produce more
output per worker.

13 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).

14 Macmillan Learning, ©2023

Chapter 14

Master two tools for 1. What Is investment?

comparing sums of 2. Tools to Analyze Investments
money at different
points in time: 3. Making Investment Decisions
 Compounding 4. The Macroeconomics of
 Discounting Investment
5. The Market for Loanable
Funds

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
16 Macmillan Learning, ©2023
 Key Definition (1
of 4) Diving into the Definition

What’s the opportunity cost of Example: What happens when

pursuing an investment project? you put $100 in the bank if the
 Forgone interest interest rate is 3%?
 How much would your money  A year later, you’ll get $100 back
grow if you put it in the bank
plus $3 in interest:
and left it to accumulate over  $100 + $3 = $103
time?
What happens if you leave that
Compounding: the accumulation money in the bank for another year?
of money over time, as you earn  A year later, you’ll get $103 back
interest on both your principal and plus $3.09 in interest:
accrued interest.  $103 + $3.09 = $106.09
 Calculates how much money
grows over time when you leave Let’s discuss the magic of compound
17 interest!
it to 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
18 Macmillan Learning, ©2023
 © Worth Publishers
The magic of compound After t years, your money
interest has grown to be worth:

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

Each year your money earns

interest and grows to be ( 1 +
r ) times larger.

Begin with an initial deposit

of $P, called the present
19
value. 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

20 Macmillan Learning, ©2023

 Compounding: Let a spreadsheet do the
work for you!

21 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

 $0.01 × (1 + 0.04)1,000 ≈ $1,000,000,000,000,000.

trillion dollars gained:

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.
22  Stopped the trust from growing. Macmillan Learning, ©2023
 Key Definition (2 Diving into the
of 4) Definition
How much are future costs or Present value: The amount of
benefits worth today? money that you would need to
 Forgone opportunity to gain invest today in order to produce
a specific benefit in the future.
from compounding interest.
 Receiving $100 in the How much money would you need
future is not the same as to put in the bank today in order
$100 today, because if I for it to grow into that sum in the
future?
got $100 today, then I could
earn interest during this  Discounting converts larger
upcoming year. future values into the smaller
present values from which
Discounting: Converting they could have grown.
future values into their equivalent
23 Macmillan Learning, ©2023
 Investment Tool 2: Discounting

Take the compounding formula and rearrange it to get the

discounting formula:

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

 Compounding formula:

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

 Discounting formula:

The discounting formula converts potential future values into their

equivalent present values.

24 Macmillan Learning, ©2023

 © Worth Publishers
Compounding and
Discounting

25 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 = $ ( 1 + 0.3)5 = $17,252.18

26 Macmillan Learning, ©2023

 Discounting: Let a spreadsheet do the
work for you!

27 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.

28 Macmillan Learning, ©2023

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

Stock market scenario: Over the a) Nominal future value in 100

past century, money in the stock years
market grew at an average rate of = $5,000 × (1 + 0.1085)100
= $148,778,353.92_________
10.85% per year.

If you put $5,000 in the stock

market in 1922, how much would it b) Real future value in 100 years
have compounded into by 2022?
Adjust 10.85% for 3% inflation:
a) Calculate the nominal future  10.85% − 3% = 7.85%
value.
 Stock market grew by 7.85% in real
b) Calculate the real future terms.
value if the inflation rate was = $5,000 × (1 + 0.0785)100
= $9,571,608.97_____________
3% per year.

30 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

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

bank.

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.
31 Macmillan Learning, ©2023
Chapter 14

Evaluate whether an 1. What Is investment?

investment opportunity is
worth pursuing: 2. Tools to Analyze Investments
 Four-step recipe
3. Making Investment Decisions
 Rational rule for
investors 4. The Macroeconomics of
 The user cost of capital Investment
5. The Market for Loanable
Funds

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
2. Predict future profits, taking
eight wind turbines, which powers
account of depreciation.
nearly 10,000 homes.
3. Calculate the present value
of all benefits and costs. The company CEO is trying to
decide whether to invest in one
 Shortcut: valuation
more turbine.
formula
4. Invest if the present value of
Your task: Figure out if this is a
benefits exceeds the worthwhile investment.
present value of costs.
33 Macmillan Learning, ©2023
 Four-step recipe (1 of 4)
STEP 1: Investing in a new turbine
Four-step recipe: requires an up-front investment of
1. Calculate the up-front cost. $4 million.

2. Predict future profits, taking

account of depreciation. STEP 2: Calculate the future
3. Calculate the present value annual profits this turbine will
of all benefits and costs. generate.
 Shortcut: valuation  This year: no profit.
formula.  First year profit: $600,000.
4. Invest if the present value of  Profit in following years: less
benefits exceeds the productive due to depreciation.
present value of costs.
 4% less output each year.
 $600,000 down to $576,000 in
the second year, then down to
34 $552,960 in the third year, [Link], ©2023
Macmillan
 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)

35 Macmillan Learning, ©2023

 Four-step recipe (2 of 4)
STEP 3: Convert all benefits and costs
Four-step recipe:
into their present values so that we can
1. Calculate the up-front cost. compare them.
2. Predict future profits,  Note that costs are already in present
taking account of value!
depreciation.  Calculate the present value of your
3. Calculate the present value future profit stream.
of all benefits and costs.
Suppose there is a 6% interest rate.
 Shortcut: valuation Then…
formula.  Present value of first year’s profit:
4. Invest if the present value = $600,000 (1 + 0.06)
of benefits exceeds the
present value of costs. = $566,038
 Present value of second year’s
profit…
36 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

37 Macmillan Learning, ©2023

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

39 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.
≥
Next year's profit
r +d
This means you should invest when: C
Present value Up-front
of future profits cost

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

profitability!
40 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!

41 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!
42  Expected loss due to forgone interest = r × C Macmillan Learning, ©2023
 Key Definition Diving into the
(3 of 4)
Definition
Putting all marginal cost pieces Wind turbine example
together! revisited:
User cost of capital: the extra  Forgone interest: The real
cost associated with using one interest rate is 6% per year.
more machine next year.  Depreciation: A $4 million
 Sometimes called the rental cost. wind turbine will be worth 4%
less at the end of the year.

User cost of capital = (r + d )

The user cost of capital is

×C
forgone interest plus
depreciation:

User cost of capital = (r + d ) × = (0.06 + 0.4) × $4 million

C
43 = $400,000 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!

44 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.
45 Macmillan Learning, ©2023
 © Worth Publishers
It’s all the same rational rule for investors!

46 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.

47 Macmillan Learning, ©2023

Chapter 14

Assess how 1. What Is Investment?

macroeconomics
conditions drive 2. Tools to Analyze Investments
investment:
 The real interest rate 3. Making Investment Decisions
and investment
4. The Macroeconomics of
 Four factors that shift
Investment
the investment line
5. The Market for Loanable
Funds

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 Next
thatyear's
willprofit
determine investment:
C
r +d

Investment will depend on…

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

50  Smaller chance the Macmillan Learning, ©2023

 Investment declines as the real interest rate rises

Real interest The higher the real interest rate,

rate the lower the present value of
future profits.
High real A  Fewer investments will pass
interest the cost-benefit test.
rate
A change in real interest rates
B causes a movement along the
Low real A
interest Investme
investment line.
rate nt line
A higher real interest rate
Total B leads to low investment.
Low High investme
investme investme nt A lower real interest rate
nt nt leads to high investment.
51 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 Decreased

investment
makes investment less profitable will…
 decrease in investment (leftward Total
investment
shift).
Macmillan Learning, ©2023
 Four investment shifters (1 of 4)
Technological advances…
Four investment  Make capital equipment more productive.
shifters:
 Boosts profits!
1. Technological  Makes the investment more
advances attractive at any given interest rate.

2. Expectations Technological advances…

 Reduce the depreciation rate.
3. Corporate taxes  Boosts future output and profits!
 Makes the investment more
4. Lending attractive at any given interest rate.
standards and
cash reserves Hence, technological advances shift the
investment line to the right.
53
…but not a change in Macmillan Learning, ©2023
 Four investment shifters (2 of 4)
Four investment Expectations:
shifters:
If managers are optimistic about future
1. Technological economics conditions…
advances  they forecast that new investments are
likely to yield robust profits.
2. Expectations  Invest more (investment line shifts
right)
3. Corporate taxes
If managers are pessimistic about future
4. Lending standards economics conditions…
and cash reserves  they invest less (investment line shifts
left).
…but not a change in
54
real interest rates. Macmillan Learning, ©2023
 Expectations of higher earning lead to increased
investment.

55 Macmillan Learning, ©2023

 Four investment shifters (3 of 4)
Four investment Corporate taxes: High corporate tax
shifters: rates mean the company keeps a smaller
share of future profits.
1. Technological  Reduces the profits you’ll get to keep from
advances any investment.
 Invest less (investment line shifts left).
2. Expectations
The wind industry has benefited from tax
3. Corporate taxes breaks.
 Tax breaks increase revenue, and hence,
profits from each turbine.
4. Lending
standards and  Invest more (investment line shifts
right).
cash reserves

56
…but not a change in Macmillan Learning, ©2023
 Four investment shifters (4 of 4)
Four investment Lending standards and cash reserves:
shifters: Investment challenge: How will you finance
your new investment?
1. Technological  How will you get the up-front cash to pay
advances for your new capital?
 Borrow the funds from a bank.
2. Expectations
 Use your company’s cash reserves.
3. Corporate taxes
More investment when…
 companies face less restrictive lending
4. Lending
standards
standards and
 or when they have enough cash reserves.
cash reserves

57
…but not a change in Macmillan Learning, ©2023
 Key take-aways: The macroeconomics of investment

A change in real interest A change in business conditions

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

58 Macmillan Learning, ©2023

Chapter 14

Forecast the long-run 1. What Is investment?

real interest rate:
2. Tools to Analyze Investments
 Supply and
demand of loanable 3. Making Investment Decisions
funds 4. The Macroeconomics of
Investment
5. The Market for Loanable
Funds

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.

60 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  They supply their funds to
interest rate, and, therefore, the businesses who want to borrow
quantity of investment. them.
Investors are the demanders.
Market for loanable funds:  They demand funds to help fund
The market for the funds used to their investments in new capital.
buy, rent, or build capital.
 Brings together savers who The financial sector is the
marketplace.
want to lend their funds, and  Banks, the bond market, and
investors who want to borrow
stock markets are where
those funds. suppliers meet demanders.
Let’s look at the features of this The real interest rate is the
61 market! Macmillan Learning, ©2023
 The market for loanable funds
The supply curve is upward- Price of loanable
sloping: funds
 A higher real interest rate raises = Real interest Supply
the benefits of savings. rate (from
saving)
The demand curve is downward-
sloping:
 A higher real interest rate makes Neutral
fewer investment projects real
Equilibrium
profitable. interest
rate
Equilibrium occurs where the
curves cross: Demand
 This determines the equilibrium (from
real interest rate. investment)

Neutral real interest rate: the Quantity of loanable

funds ($)©2023
62 interest rate that operates when the Macmillan Learning,
 Shifting the supply of loanable funds

A decrease in saving shifts the Real interest

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

An increase in saving shifts the 3.5 Increased

% saving
supply of loanable funds to the
right… 3.0
 Lower real interest rate. %
3.5
%
There are three economic actors
whose change in savings will impact Demand
the supply of loanable funds: (investment)
1. Private savers
2. The government Quantity of loanable
3. Foreigners funds
63 Macmillan Learning, ©2023
 Supply shifter 1: Changes in personal saving
rates
Personal saving refers to saving Pandemic example: People stayed home
and cut back spending, and the government
by households of whatever income
sent out checks. The result was an increase
they don’t spend or pay as taxes. in savings, which shifted the supply of
 putting money in the bank. loanable funds to the right.
Real
 paying down your debt. interest Initial
Increased
rate supply
 Frees up loanable funds for savings
others to use.

Anything that shifts people’s Demand

(investment
willingness to save will shift the )
supply of loanable funds.
Quantity
of loanable
64 funds©2023
Macmillan Learning,
 Supply shifter 2: Government saving shifts due
to changing budget surpluses and deficits
Government saving refers to saving by the
government.

Budget surplus: when Budget deficit: when the

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

Budget deficit and crowding out.

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

An increase in investment shifts the Real interest

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

A decrease in investment shifts the

4% Increased
demand for loanable funds to the left…
 lower real interest rate. investmen
3% t
Any factor that shifts the investment line
will also shift the demand for loanable 2%
funds: Initial demand
(investment)
1. Technological advances
2. Expectations Decreased
investment
3. Corporate tax cuts
4. Easier lending standards + larger cash Quantity of loanable
reserves funds
68 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

69 Macmillan Learning, ©2023

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

Step 2: Leftward or rightward

shift? rnew
 Lower future profits will Demand
reduce investment (shift
Decreas
left).
ed
(shifter: expectations) Demand
Qne Q0ld Quantity
Step 3: Assess equilibrium w
of loanable
73outcomes. funds
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.

74 Macmillan Learning, ©2023

Chapter 14

1. Spending on new capital

assets that increase the
economy’s productive capacity 1. What Is investment?
2. Compounding and discounting 2. Tools to Analyze Investments
3. Rational rule for investors
3. Making Investment Decisions
4. Four investment shifters
5. The market for the funds used 4. The Macroeconomics of
to buy, rent, or build capital Investment
5. The Market for Loanable Funds

Macmillan Learning, ©2023