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Capital Markets

Capital Markets. Savings, Investment, and Interest Rates. Some Useful Terminology. Savings: Current income which is deferred for future consumption (i.e., not spent). Some Useful Terminology. Savings: Current income which is deferred for future consumption (i.e., not spent)

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Capital Markets

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  1. Capital Markets Savings, Investment, and Interest Rates

  2. Some Useful Terminology • Savings: Current income which is deferred for future consumption (i.e., not spent)

  3. Some Useful Terminology • Savings: Current income which is deferred for future consumption (i.e., not spent) National Income: $8,512.3 B + Dividend Payments, Interest, Gov’t Transfers, etc.: $582.5B • Taxes: $1,077.2 B = Personal Disposable Income: $8,017.6 B - Personal Consumption Expenditures: $7,727.2 B = Personal Savings: $290.4B (3.5% of Personal Income)

  4. Some Useful Terminology • Savings: Current income which is deferred for future consumption (i.e., not spent) National Income: $8,512.3 B + Dividend Payments, Interest, Gov’t Transfers, etc.: $582.5B • Taxes: $1,077.2 B = Personal Disposable Income: $8,017.6 B - Personal Consumption Expenditures: $7,727.2 B = Personal Savings: $290.4B (3.5% of Personal Income) • Note that there are many ways to save (savings account, bonds, stocks, etc.)

  5. Some Useful Terminology • Investment: The purchase of new capital goods.

  6. Some Useful Terminology • Investment: The purchase of new capital goods. • Gross Investment: Total purchases of new capital goods

  7. Some Useful Terminology • Investment: The purchase of new capital goods. • Gross Investment: Total purchases of new capital goods • Gross Private Investment: $1,611.2 B • Gross Public Investment: $355 B

  8. Some Useful Terminology • Investment: The purchase of new capital goods. • Gross Investment: Total purchases of new capital goods • Gross Private Investment: $1,611.2 B • Gross Public Investment: $355 B • Net Investment: Gross investment less depreciation of existing capital (capital consumption) • Net Private Investment:$500 B • Net Public Investment: $250 B

  9. NIPA Accounts • Recall, the accounting identity in the NIPA accounts: GDP = C + I + G + NX

  10. NIPA Accounts • Recall, the accounting identity in the NIPA accounts: GDP = C + I + G + NX • GDP = Gross Private Savings + Taxes + C

  11. NIPA Accounts • Recall, the accounting identity in the NIPA accounts: GDP = C + I + G + NX • GDP = Gross Private Savings + Taxes + C Gross Private Savings = I + (G-T) + NX I (Public + Private) : $1,966 B + (G-T): $106B + NX: - $559B Gross Private Savings: $1,513B (16% of GDP)

  12. NIPA Accounts • Recall, the accounting identity in the NIPA accounts: GDP = C + I + G + NX • GDP = Gross Savings + Taxes + C I + (G-T) + NX = Gross Private Savings I (Public + Private) : $1,966 B + (G-T): $123B + NX: - $487B Gross Private Savings: $1,513B Personal Savings ($290B) = Gross Private Saving ($1,513B) - Depreciation

  13. Interest Rates • What is an interest rate?

  14. Interest Rates • What is an interest rate? • The interest rate is the relative price of current spending in terms of foregone future income.

  15. Interest Rates • What is an interest rate? • The interest rate is the relative price of current spending in terms of foregone future income. • Example: if the interest rate is 5% (Annual), you must give up $1.05 worth of next year’s income in order to increase this year’s spending by $1.

  16. Interest Rates:1987-2003

  17. Interest Rates:1987-2003

  18. The Yield Curve

  19. Yield Curves • What determines the shape of the yield curve? • Segmented Markets Hypothesis • Expectations Hypothesis • Preferred Habitat Hypothesis

  20. Interest Rates:1987-2003

  21. Interest Rates • Treasury Securities (1 - 5%) • Agency Securities (1 - 5%) • Municipal Bonds (3 – 5%) • Corporate Bonds (6 – 11%) • Preferred Stock (5 – 15%) • Asset Backed Securities (4 – 5%)

  22. Interest Rates • Treasury Securities (1 - 5%) • Agency Securities (1 - 5%) • Municipal Bonds (3 – 5%) • Corporate Bonds (6 – 11%) • Preferred Stock (5 – 15%) • Asset Backed Securities (4 – 5%) • “Risky” Rate = Risk Free Rate + Risk Premium

  23. Real vs. Nominal Interest Rates • As with any other variable, the nominal interest rate is in terms of dollars. (the cost of a current dollar in terms of forgone future dollars). To calculate the real interest rate, we need to correct for the purchasing power of those dollars.

  24. Real vs. Nominal Interest Rates • As with any other variable, the nominal interest rate is in terms of dollars. (the cost of a current dollar in terms of forgone future dollars). To calculate the real interest rate, we need to correct for the purchasing power of those dollars. • Exact: (1+i ) = (1+ r )*(1 + inflation rate)

  25. Real vs. Nominal Interest Rates • As with any other variable, the nominal interest rate is in terms of dollars. (the cost of a current dollar in terms of forgone future dollars). To calculate the real interest rate, we need to correct for the purchasing power of those dollars. • Exact: (1+i ) = (1+ r )*(1 + inflation rate) • Approximation: i = r + inflation rate

  26. Real/Nominal Interest Rates

  27. Real vs. Nominal Interest Rates • As with any other variable, the nominal interest rate is in terms of dollars. (the cost of a current dollar in terms of forgone future dollars). To calculate the real interest rate, we need to correct for the purchasing power of those dollars. • Exact: (1+i ) = (1+ r )*(1 + inflation rate) • Approximation: i = r + inflation rate • How can real interest rates be negative?

  28. Real vs. Nominal Interest Rates • As with any other variable, the nominal interest rate is in terms of dollars. (the cost of a current dollar in terms of forgone future dollars). To calculate the real interest rate, we need to correct for the purchasing power of those dollars. • Exact: (1+i ) = (1+ r )*(1 + inflation rate) • Approximation: i = r + inflation rate • How can real interest rates be negative? • Ex ante vs. ex post

  29. Present Value • With a positive interest rate, income received in the future is less valuable that income received immediately.

  30. Present Value • With a positive interest rate, income received in the future is less valuable that income received immediately. • At a 5% annual interest rate, $1.05 to be received in one year is equivalent to $1 to be received today (because $1 today could be worth $1.05) $1(1.05) = $1.05

  31. Present Value • With a positive interest rate, income received in the future is less valuable that income received immediately. • At a 5% annual interest rate, $1.05 to be received in one year is equivalent to $1 to be received today (because $1 today could be worth $1.05) $1(1.05) = $1.05 • Therefore, the present value of $1.05 to be paid in one year (if the annual interest rate is 5%) is $1.

  32. Present Value • With a positive interest rate, income received in the future is less valuable that income received immediately. • At a 5% annual interest rate, $1.05 to be received in one year is equivalent to $1 to be received today (because $1 today could be worth $1.05) $1(1.05) = $1.05 • Therefore, the present value of $1.05 to be paid in one year (if the annual interest rate is 5%) is $1. • In general, the PV of $X to be paid in N years is equal to PV = $X/(1+i)^N

  33. Income vs. Wealth • Your wealth is defined and the present value of your lifetime income.

  34. Income vs. Wealth • Your wealth is defined and the present value of your lifetime income. • For example, suppose you expect your annual income to be $50,000 per year for the rest of your life. If the annual interest rate is 3%: Wealth = $50,000 + $50,000/(1.03) + $50,000/(1.03)^2 + …… = $50,000/(.03) = $1,666,666 (Approx)

  35. Household Savings • Without an active capital markets, household consumption is restricted to equal current income (that is, C=Y)

  36. Household Savings • Without an active capital markets, household consumption is restricted to equal current income (that is, C=Y) • With capital markets, the present value of lifetime consumption must equal the present value of lifetime income (assuming all debts are eventually repaid)

  37. A two period example • Suppose that your current income is equal to $50,000 and you anticipate next year’s income to be $60,000. The current interest rate is 5%.

  38. A two period example • Suppose that your current income is equal to $50,000 and you anticipate next year’s income to be $60,000. The current interest rate is 5%. • In the absence of capital markets, your consumption stream would be $50,000 this year and $60,000 next year.

  39. Consumption Possibilities

  40. Borrowing to increase current consumption • To increase your current consumption, you could take out a loan. Your current consumption would now be C = $50,000 + Loan

  41. Borrowing to increase current consumption • To increase your current consumption, you could take out a loan. Your current consumption would now be C = $50,000 + Loan • However, you must repay your loan next year. This implies that C’= $60,000 – (1.05)Loan

  42. Borrowing to increase current consumption • To increase your current consumption, you could take out a loan. Your current consumption would now be C = $50,000 + Loan • However, you repay your loan next year. This implies that C’= $60,000 – (1.05)Loan • For example, if you take out a $10,000 loan, your current consumption would be $60,000, while your future income would be $60,000 - $10,000(1.05) = $49,500

  43. Consumption Possibilities

  44. Borrowing Limits • Note that you need to be able to repay your loan next year. Therefore, $60,000 > (1.05)Loan

  45. Borrowing Limits • Note that you need to be able to repay your loan next year. Therefore, $60,000 = (1.05)Loan • Your maximum allowable loan is $60,000/1.05 = $57,143 (this is associated with zero future consumption)

  46. Borrowing Limits • Note that you need to be able to repay your loan next year. Therefore, $60,000 = (1.05)Loan • Your maximum allowable loan is $60,000/1.05 = $57,143 (this is associated with zero future consumption) • Therefore, your maximum current consumption is $107,143

  47. Consumption Possibilities

  48. Consumption Possibilities

  49. Saving to increase future consumption • You could increase future consumption by saving some of your income (i.e. a negative loan). Suppose you put $20,000 in the bank, your current consumption is now $30,000.

  50. Saving to increase future consumption • You could increase future consumption by saving some of your income (i.e. a negative loan). Suppose you put $20,000 in the bank, your current consumption is now $30,000. • Next year, your bank account will be worth $20,000(1.05) = $21,000. Therefore, your future consumption will be $81,000

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