Chapter 12
Investment and
Financial Markets
The housing market is a
perfect example of the close
links between investment and
finance.
Prepared By Brock Williams
Learning Objectives
1. Explain why investment spending is a
volatile component of GDP
2. Discuss the concept of present value
3. Describe the role of interest rates in
making investment decisions
4. List the ways that financial intermediation
can facilitate investment.
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12-2
12.1 AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN
• accelerator theory
The theory of investment that says that current
investment spending depends positively on the
expected future growth of real GDP.
 FIGURE 12.1
Investment Spending as a
Share of U.S. GDP, 1970–2011
The share of investment
as a component of GDP
ranged from a low of
about 10 percent in 1975
to a high of over 18
percent in 2000.
The shaded areas
represent U.S. recessions.
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12-3
12.1 AN INVESTMENT: A PLUNGE
INTO THE UNKNOWN
• procyclical
Moving in the same direction as real
GDP.
• multiplier-accelerator model
A model in which a downturn in real
GDP leads to a sharp fall in
investment, which triggers further
reductions in GDP through the
multiplier.
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12-4
APPLICATION
1
ENERGY PRICE UNCERTAINTY REDUCES
INVESTMENT SPENDING
APPLYING THE CONCEPTS #1: How do fluctuations in energy
prices affect investment decisions by firms?
One important way volatility of oil prices can hurt the economy is by
creating uncertainty for firms making investment decisions.
Consider whether a firm should invest in an energy-saving technology
for a new plant:
• If energy prices remain high, it may be profitable to
invest in energy-saving technology.
• If prices fall, these investments would be unwise.
• If future oil prices are uncertain, a firm may simply delay
building the plant until the path of oil prices are clear.
When firms are faced with an increasingly uncertain future, they will
delay their investment decisions until the uncertainty is resolved.
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12-5
12.2 EVALUATING THE FUTURE
Understanding Present Value
PRESENT VALUE AND INTEREST RATES
• present value
The maximum amount a person is willing to pay today to receive a payment
in the future.
K
present value =
(1  i )t
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
1
The present value—the value today—of a given payment in the future is the maximum
amount a person is willing to pay today for that payment.
2
As the interest rate increases, the opportunity cost of your funds also increases, so the
present value of a given payment in the future falls. In other words, you need less
money today to get to your future “money goal.”
3
As the interest rate decreases, the opportunity cost of your funds also decreases, so
the present value of a given payment in the future rises. In other words, you need
more money today to get to your money goal.
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12-6
12.2 EVALUATING THE FUTURE
Real and Nominal Interest Rates
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—the purchasing
power—not the face value of money.
• nominal interest rate
Interest rates quoted in the market.
• real interest rate
The nominal interest rate minus the
inflation rate
• expected real interest rate
The nominal interest rate minus the
expected inflation rate.
real rate  nominal rate  inflation rate
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12-7
APPLICATION
2
THE VALUE OF AN ANNUITY
APPLYING THE CONCEPTS #2: How can understanding the concept of
present value help us evaluate an annuity?
• Suppose you and your employer both had set aside funds for the day you retire at age 65. Just
before you retire, your employer offers you’re the following options: 1) You can have the
$500,000 that was set aside, or 2) the firm would take the $500,000 and purchase you an
annuity contract---a financial instrument that would pay you a fixed annual payment of $35,000
per year as long as you live.
• The first step in making this decision would be to calculate the present value of the annuity
payments and compare it to the $500,000. Of course, you do not know for sure how long you
would live, so you would need some estimates of the probability of surviving at each age into the
future. You would multiply that probability by the yearly annuity payment to obtain an expected
annuity payment for every future year. Finally, you would need to choose an interest rate and
calculate the expected present value of the annuity payments and compare it to the $500,000.
• Hopefully, your firm offered you a well-priced annuity. But the decision is still yours. The annuity
would be a better deal for you if you were healthier than average and expected to live longer
than the average person. On the other hand, if you had poor health, it would not be a good idea.
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12-8
12.2 EVALUATING THE FUTURE
• There are different types of interest investments.
• Corporate bonds are considered more risky than federal government
bonds, so pay a higher interest rate.
• Long term investments are more risky than short term investments, so
again pay a higher interest rate.
 FIGURE 12.2
Interest Rates on
Corporate and
Government
Investments,
2002–2011
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12-9
12.3 UNDERSTANDING INVESTMENT
DECISIONS
 FIGURE 12.3
The Relationship between Real Interest
Rates and Investment Spending
As the real interest rate declines,
investment spending in the economy
increases.
• neoclassical theory of investment
A theory of investment that says
both real interest rates and taxes
are important determinants of
investment.
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12-10
12.3 UNDERSTANDING INVESTMENT
DECISIONS
Investment and the Stock Market
• retained earnings
Corporate earnings that are not paid
out as dividends to their owners.
• corporate bond
A bond sold by a corporation to the
public in order to borrow money.
• Q-theory of investment
The theory of investment that links
investment spending to stock prices.
price of a stock = present value of expected future dividend payments
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12-11
12.3 UNDERSTANDING INVESTMENT
DECISIONS
 FIGURE 12.4
The Stock Market and Investment Levels, 1997–2003
Both the stock market and
investment spending rose
sharply from 1997, peaking in
mid-2000.
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12-12
12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• liquid
Easily convertible into money on short notice.
 FIGURE 12.5
Savers and Investors
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12-13
12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• financial intermediaries
Organizations that receive funds from
savers and channel them to investors.
 FIGURE 12.6
Financial Intermediaries
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12-14
12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
• securitization
The practice of purchasing loans,
re-packaging them, and selling
them to the financial markets.
• leverage
Using borrowed funds to
purchase assets.
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12-15
12.4 HOW FINANCIAL INTERMEDIARIES
FACILITATE INVESTMENT
When Financial Intermediaries Malfunction
• bank run
Panicky investors simultaneously
trying to withdraw their funds from
a bank they believe may fail.
• deposit insurance
Federal government insurance on
deposits in banks and savings
and loans.
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12-16
APPLICATION
4
SECURITIZATION: THE GOOD, THE BAD, AND
THE UGLY
APPLYING THE CONCEPTS #4: How have recent financial
innovations created new risks for the economy?
• As securitization developed, it allowed financial intermediaries to provide
new funds for borrowers to enter the housing market.
• As the housing boom began in 2002, lenders and home purchasers began
to take increasing risks. Lenders made “subprime” loans to borrowers with
limited ability to actually repay their mortgages.
• Some households were willing to take on considerable debt because they
were confident they could make money in a rising housing market. Lenders
securitized the subprime loans and financial firms offered exotic investment
securities to investors based on these loans. Many financial institutions
purchased these securities without really knowing what was inside them.
• When the housing boom stopped and borrowers stopped making payments
on subprime loans, it created panic in the financial market. Effectively,
through securitization the damage from the subprime loans spread to the
entire financial market, causing a major crisis.
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12-17
KEY
TERMS
accelerator theory
neoclassical theory of investment
bank run
nominal interest rate
corporate bond
present value
deposit insurance
procyclical
expected real interest rate
Q-theory of investment
financial intermediaries
real interest rate
leverage
retained earnings
liquid
securitization
multiplier-accelerator model
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12-18
Questions?
Homework
Ch12, pp 269-270
1.4, 2.1, 2.2, 2.7,
3.9, 4.6, 4.9
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