ECO102: Principles of Macroeconomics Lecture 4 PDF

ECO102: Principles of Macroeconomics Lecture 4 Kurt See, PhD Department of Economics University of Toronto Lecture 4 – Investment (Chapter 14) 4A Investment Spending 14.1 4B Making Investment Decisions 14.2-14.3 4C Macroec...

ECO102: Principles of Macroeconomics Lecture 4 Kurt See, PhD Department of Economics University of Toronto Lecture 4 – Investment (Chapter 14) 4A Investment Spending 14.1 4B Making Investment Decisions 14.2-14.3 4C Macroeconomics of Investment 14.4 4D Market for Loanable Funds 14.5 Self-Study: The Financial Sector (15.1-15.3; skip 15.4-15.5) Introduction Savings (S) and Investment (I)  linked to growth and living standards Financial markets  coordinate S and I Potentially important effects on “real” economy ─Through effects on TFP ─Financial Crisis International dimension  Closed versus open economy Defining Investment Investment: spending on new capital assets that will be used for future production Recall: Investment = Residential + Business Fixed + Inventory Recall: Change in Capital = Investment - Depreciation Recall: Investment is very valuable when MPK is high (e.g. in developing countries) to increase economic growth Investment is not buying financial assets! Defining Investment How do we grow the capital stock (K)? Investment spending (I) increases, and… Depreciation decreases the capital stock Recall: investment spending is spending on capital… … not saving (= financial investing) From Lecture 3: Capital and GDP Where: GDP/L = output per worker K/L = capital per worker f(.) = production function Investment Changes Quickly, Capital Stock Slowly Defining Savings Saving = Current Income – Spending on Current Consumption Definition applies to individuals and the aggregate Suppose an individual receives income = 1000, spends consumption = 900 Saving = Saving rate = For individuals, saving increases wealth: Change in Wealth = Saving + Net Capital Gains Lecture 4 – Investment (Chapter 14) A. Investment Spending B. Making Investment Decisions C. Macroeconomics of Investment D. Market for Loanable Funds Case l: One Year, no Depreciation Would you be willing to invest today $950 in a project that pays $1,000 next year if the (real) interest rate is 4%? Today Next year PV = Present Value CF = cash-flow r = rate of return (interest rate) Step 1: bring cash-flow to same point in time: PV = CF / (1+r) Step 2: compare costs and benefits Case l: One Year, no Depreciation (2) At which interest rates would you CF = $1,000 invest $950 today? Interest rate PV PV = CF / (1+r) 4% 962 5% 952 Investment decision: invest in 6% 943 those projects where PV > Investment 7% 935 8% 926 Question You receive $1,000 for sure next year. If the interest rate is 10%, what is the present value of this money? a. $100 b. $909 c. $990 d. $1,100 e. $1,010 Case ll: Two Years, no Depreciation Now receive 1,000 in one year AND 1,000 in two years, interest is 5% per year Today Next year Two years Case ll: Two Years, no Depreciation (2) If your initial investment is $1,825 today, at which interest rates would you invest to receive 1,000 next year and 1,000 in two years? Cashflow (CF) = $1,000, T = 2 years Interest rate PV PV of CF at t=1 PV of CF at t=2 PV total 4% 962 925 1,886 5% 952 907 1,859 6% 943 890 1,833 7% 935 873 1,808 8% 926 857 1,783 Scenario: Air Canada purchases an aircraft Suppose that an Airbus A350 costs $4,000,000 in 2018. the real interest rate is 6% the depreciation rate is 4% (e.g. as the aircraft gets old, in needs to stay under maintenance more often) the aircraft will bring in $600,000 in revenue on its first year of operations Question: Should Air Canada invest in the aircraft?  In-class example walk through Year Future revenue = Last year’s revenue × (1 − Present value of future revenue = Future 𝑑) 𝟏 revenue × 𝟏 𝒓 𝒕 0 0 0  In-class example walk through Year Future revenue = Last year’s revenue × (1 − Present value of future revenue = Future 𝑑) 𝟏 revenue × 𝟏 𝒓 𝒕 0 0 0 1 600000 2 3 4 …  In-class example walk through Year Future revenue = Last year’s revenue × (1 − Present value of future revenue = Future 𝑑) 𝟏 revenue × 𝟏 𝒓 𝒕 0 0 0 1 600000 1 566038 × 1+𝑟 2 3 4 …  In-class example walk through Year Future revenue = Last year’s revenue × (1 − Present value of future revenue = Future 𝑑) 𝟏 revenue × 𝟏 𝒓 𝒕 0 0 0 1 600000 1 566038 × 1+𝑟 × (1 − 𝑑) 2 576000 3 4 …  In-class example walk through Year Future revenue = Last year’s revenue × (1 − Present value of future revenue = Future 𝑑) 𝟏 revenue × 𝟏 𝒓 𝒕 0 0 0 1 600000 1 566038 × 1+𝑟 × (1 − 𝑑) 2 576000 1 512638 × 1+𝑟 3 4 …  In-class example walk through Year Future revenue = Last year’s revenue × (1 − Present value of future revenue = Future 𝑑) 𝟏 revenue × 𝟏 𝒓 𝒕 0 0 0 1 600000 1 566038 × 1+𝑟 × (1 − 𝑑) 2 576000 1 512638 × Add this 1+𝑟 all up until 3 552960 1 464276 × (1 − 𝑑) × 𝑡→∞ 1+𝑟 4 530842 1 420476 You will × × (1 − 𝑑) 1+𝑟 get: $6M! … … … Putting it all together Sum will approach $6 million! Let’s work it out with a spread sheet. Investment Rule We don’t need to use a complicated spreadsheet. Investment rule: Next year's revenue > Cost r +d In our example: Same as our spreadsheet  sum! An Alternative Perspective Instead of asking: Should I buy one more machine for many decades? We could ask: Should I buy one more machine for one more year? Answer: Yes, if marginal benefits exceed marginal costs! Marginal cost = user cost of capital Forgone interest cost: Depreciation cost: Marginal benefit = Next year’s revenue  Same MB > MC  Next year’s revenue > (r+d)*C investment rule from the previous slide! Question You receive $1,000 next year and then every year after indefinitely. Depreciation is zero and the interest rate is 5%. Using the investment rule of thumb, what is the present value? a. $200 b. $952 c. $1,050 d. $20,000 Making Investment Decisions Step 1: Bring the value of future dollars to today by discounting (PV) after accounting for depreciation. Step 2: Look at the initial investment today (I) Step 3: Investment rule: if I < PV, then invest What happens to investment if the interest rate increases? Midterm 1 Announcements Lecture 4 – Investment (Chapter 14) A. Investment Spending B. Making Investment Decisions C. Macroeconomics of Investment D. Market for Loanable Funds A. Investment = Saving Where does investment (I) come from? Tool : For now: assume a closed economy (no trade) => NX = 0 Question 2 In a closed economy you have the following information: Y = 450, C = 300, I = ? and G = 25. How much is Savings in the economy? a. 0 b. 25 c. 125 d. 175 e. Can’t say with this information B. Investment = Saving, with a Government National Savings (S) = private savings + public savings Government makes Transfers (Tr) to households Households pay Taxes (T) to government Private savings: Public savings: Combine: C. Investment and Saving in an Open Economy S ≠ I Why? Rewrite: Net Exports (NX): value of exports minus imports of goods and services… … happens to be equal to: Net Foreign Investment (NFI): value of financial capital flows to other countries minus capital flows coming in. C. Investment and Saving in an Open Economy Rewrite: Why do Net Exports (NX) and Net Foreign Investments (NFI) have equal value? NFI > 0 => S > I and Capital Outflow Must be that: NX > 0, which means that X > M NFI < 0 => S < I and Capital Inflow Must be that: NX < 0, which means that X < M Lecture 4 – Investment (Chapter 14) A. Investment Spending B. Making Investment Decisions C. Macroeconomics of Investment D. Market for Loanable Funds D. Market for Loanable Funds Where do savers (S) and capital investors (I) meet? Market for loanable funds Demand: Relationship between quantity of funds demanded (borrowers) and the price Supply: Relationship between quantity of funds supplied (lenders) and the price What is the price? D. Market for Loanable Funds – Demand (I) Real interest rate (r) Investment D. Market for Loanable Funds – Supply (S) Real interest rate (r) Saving D. Market for Loanable Funds – Equilibrium Real interest rate (r) Saving r* Investment Investment, I* = S* Saving Question l. When the interest rate increases, national savings increases ll. When the interest rate increases, investment spending decreases a. l is not true, ll is not true b. l is true, ll is not true c. l is not true, ll is true d. l is true, ll is true D. Market for Loanable Funds – Shift the Curves Shift domestic demand for loanable funds 1. Technological advances 2. Expectations 3. Corporate taxes 4. Lending standards and cash reserves Shift domestic supply for loanable funds 1. Changes in private savings behavior 2. Changes in government budget balance 3. Global shocks (open economy) Question: market for loanable funds Suppose the government spending begins to increase in preparation for a potential military conflict. At the same time, a new technology breakthrough improves the productivity of capital goods. What is the ultimate effect on ∗ ? r A) ∗ B) ∗ C) ∗ unchanged D) Cannot determine; depends on slopes Q 41 D. Increase in Government Spending  Open Economy with World Interest Rate r Saving in A r Saving in B r* in A r* in B Investment A Investment B I* = S* Investment, I* = S* Investment, Saving A Saving B  Open Economy with World Interest Rate (2) r Saving in A r Saving in B rworld Investment A Investment B Investment, Investment, Saving A Saving B  Open Economy with World Interest Rate (3) r Saving in A r Saving in B NFIB > 0 rworld NFIA < 0 Investment A Investment B SA IA IB SB Real and Nominal Interest Rates Market for loanable funds: real interest rate (why?) Book: “neutral” real interest rate => long-run Short-run? => discuss in context of monetary policy Interest rate on financial assets: nominal interest rate Recall (Lecture 2): real interest rate = nominal interest – inflation Rewrite: nominal interest = real interest + inflation D. Estimates of the (neutral) Real Interest Rate Recap Investment Investment spending is important for economic growth Higher interest rates? Lower Investment (discounting) User cost of capital is forgone interest plus depreciation Market for loanable funds: saving and investment (long run or neutral) Real interest rate