1. Investment andFinancial Markets F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY: © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez

2. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 23 1 How do fluctuations in energy prices affect investment decisions by firms? Energy Price Uncertainty Reduces Investment Spending 2How can understanding the concept of present value help a lucky lottery winner? Options for a Lottery Winner 3Why are there different types of interest rates in the economy? Interest Rates Vary by Risk and Length of Loan 4How does the government affect the home mortgage market today? Fannie Mae and Freddie Mac Facilitate Homeownership: But Do They Increase Risk?

3. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 23 AN INVESTMENT: A PLUNGE INTO THE UNKNOWN 12.1 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, 1970–2005

4. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 23 AN INVESTMENT: A PLUNGE INTO THE UNKNOWN 12.1 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.

5. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 23 ENERGY PRICE UNCERTAINTY REDUCES INVESTMENT SPENDING APPLYING THE CONCEPTS #1: How do fluctuations in energy prices affect investment decisions by firms? One important channel by which 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 new energy-saving technology for the plant. 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.

6. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 23 EVALUATING THE FUTURE 12.2 Understanding Present Value present value The maximum amount a person is willing to pay today to receive a payment in the future. PRESENT VALUE AND INTEREST RATES

7. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 23 EVALUATING THE FUTURE 12.2 Understanding Present Value PRESENT VALUE AND INTEREST RATES Let’s summarize our discussion of present value: 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. 2As the interest rate increases, the opportunity cost of your funds also increases, so the present value of a given payment in the future falls. 3As the interest rate decreases, the opportunity cost of your funds also decreases, so the present value of a given payment in the future rises.

8. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 23 OPTIONS FOR A LOTTERY WINNER APPLYING THE CONCEPTS #2: How can understanding the concept of present value help a lucky lottery winner? The lucky winner of a lottery was given an option: Receive $1 million a year for 20 years Receive $10 million today Why would anyone take the $10 million today? To determine which payment option is best, our lottery winner would first need to: Calculate the present value of $1 million for each of the 20 years Add up the result Compare it to the $10 million being offered to her today Example: With an 8 percent interest rate, the present value of an annual payment of $1 million every year for 20 years is $9.8 million. Best option: If interest rates exceed 8 percent, it is better to take the $10 million dollars.

9. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 23 DEFENSE COMPANIES CASH IN ON CLIMATE OF FEAR Many analysts continue to recommend smaller defense stocks believing the continued trend still holds the potential for increased stock prices. A number of technology companies are developing “biometrical scanning devices, face or behavior recognition systems, detection systems for explosives,” and a host of other defense related products. Research and development spending in this industry is also up with British defense companies increasing R & D spending by 61 percent last year alone. As long as the political climate continues to favor defense spending, companies are more than happy to provide them with new and better products. Defense companies can cash in on fear since the increased threat of terrorism stimulates demand for their products. As projected cash flows increase then so does the stock price since the true value of these companies should be the present value of their future expected cash flows. Terrorism and global conflicts have escalated government spending on military and defense items to the point where many defense stocks have doubled in value since 9/11. Some stocks have increased as much as fivefold in price over the same period. Extra Application 8

10. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 23 EVALUATING THE FUTURE 12.2 Real and Nominal Interest Rates nominal interest rate Interest rates quoted in the market. real interest rate The nominal interest rate minus the inflation rate.

11. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 23 EVALUATING THE FUTURE 12.2 Real and Nominal Interest Rates expected real interest rate The nominal interest rate minus the expected inflation rate.

12. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 23 INTEREST RATES VARY BY RISK AND LENGTH OF LOAN APPLYING THE CONCEPTS #3: Why are there different types of interest rates in the economy? Riskier loans and loans for longer maturities typically have higher interest rates. Notice that rates for corporate bonds are higher than the rates for 10-year Treasury bonds. Reason: Corporations are less likely to pay back their loans than the U.S. government.  FIGURE 12.2 Interest Rates on Corporate and Government Investments, 2002-2005

13. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 23 UNDERSTANDING INVESTMENT DECISIONS 12.3  FIGURE 12.3 The Relationship Between Real Interest Rates, Spending, and Investment neoclassical theory of investment A theory of investment that says both real interest rates and taxes are important determinants of investment.

14. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 23 UNDERSTANDING INVESTMENT DECISIONS 12.3 Investment and the Stock Market retained earnings Corporate earnings that are not paid out as dividends to its 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.

15. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 23 UNDERSTANDING INVESTMENT DECISIONS 12.3 Investment and the Stock Market  FIGURE 12.4 The Stock Market and Investment Levels, 1997–2003

16. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 23 DOW PLUNGES The Dow Jones Industrial Average fell by more than 150 points. This index measures only 30 stocks but it is typically indicative of the overall market. Other broader market measures such as the NASDAQ and the S & P 500 fell as well. Why is the stock market so sensitive to inflation data? Financial markets are extremely sensitive to interest rate changes and billions of dollars (and other currencies) move around the world based on minor changes in interest rates and other variables. The higher than expected inflation caused many investors to reevaluate their financial positions and adjust their portfolios accordingly. This portfolio rebalancing led to the large drop in the DJIA. The U.S. Labor Department indicated that inflation was higher than anticipated. The consumer price index (CPI) increased by 0.6 percent during the month of April. However, more alarming was the 0.3 percent increase in the core CPI, the measure that excludes the usually volatile food and energy components. The higher inflation overshadowed the slight drop in crude oil prices and sent the stock market tumbling. Extra Application 5

17. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 23 STOCKS STRUGGLE AFTER FED CHIEF’S ECONOMIC VIEW Market analysts have a better understanding of Bernanke’s position on the economy. Most believe that Bernanke will establish the Fed as hawkish on inflation. Investors will pay close attention to economic indicators for signs of inflation. New Fed chairman Ben Bernanke’s first congressional testimony on monetary policy kept the stock market jittery. Investors listened for any indication of future interest rate movement and responded negatively when Bernanke indicated that more rate hikes may be in the Fed’s future. Bernanke’s concern over budget deficits made investors jittery as well. However, Bernanke reassured the committee that economic growth appeared on track and inflation was currently under control. Extra Application 7 Since the true value of a stock should be a function of the present value of the expected cash flows the company will generate, an increase in interest rates will decrease that present value. Investors will revalue stocks given the new expected higher (or lower) interest rates. The expectation of higher interest rates will cause fewer potential investors to demand stocks and also cause existing investors to supply more stocks at a given price. These two shifts result in a new equilibrium at a lower price.

18. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 23 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT 12.4 liquid Easily convertible into money on short notice.  FIGURE 12.5 Savers and Investors

19. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 23 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT 12.4 financial intermediaries Organizations that receive funds from savers and channel them to investors.  FIGURE 12.5 Financial Intermediaries

20. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 23 HOW FINANCIAL INTERMEDIARIES FACILITATE INVESTMENT 12.4 bank run Panicky investors simultaneously trying to withdraw their funds from a bank they believe may fail. When Financial Intermediaries Malfunction deposit insurance Federal government insurance on deposits in banks and savings and loans.

21. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 21 of 23 FANNIE MAE AND FREDDIE MAC FACILITATE HOMEOWNERSHIP: BUT DO THEY INCREASE RISK? APPLYING THE CONCEPTS #4: How does the government affect the home mortgage market today? Fannie Mae and Freddie Mac are financial intermediaries that facilitate home ownership in the United States. Here is how they operate: They purchase home mortgages from S&Ls and banks that have made loans to homeowners. They package together the mortgages they purchase and then sell guaranteed, mortgage-backed securities to investors. They borrow money from other investors in the market in order to buy the mortgages from banks and S&Ls. Economists and investors have begun to worry whether Fannie Mae and Freddie Mac are fully safe. Reasons: Interest rates can rise and fall sharply. Homeowners can refinance or pay off their mortgages when rates fall.

22. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 22 of 23 TEENS LACK FINANCIAL LITERACY Only 14.2 percent of students correctly identified stocks as offering higher growth potential than U.S. savings bonds. Sixty-two percent incorrectly identified retirement income from a company pension plan as Social Security. Demographic differences also exist with seniors from higher income households being more financially literate than those from the lowest income groups and white students scoring higher than black and Hispanic students. Why is this lack of financial acumen considered to be problematic? Lack of financial acumen probably contributes further to income disparities. While many may increase their earning potential through education, many will not retain and grow wealth without financial knowledge. The Federal Reserve released the results of a recent survey about the financial and economic literacy of U.S. high school seniors. This latest survey showed that high school seniors correctly answered only 52.4 percent of questions, a very slight improvement over last year’s results where seniors answered 52.3 percent of the questions correctly. Both years represent improvement over the 2002 survey results of 50.2 percent. Extra Application 6

23. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 23 of 23 accelerator theory bank run corporate bond deposit insurance expected real interest rate financial intermediaries liquid multiplier-accelerator model neoclassical theory of investment nominal interest rates present value procylical Q-theory of investment real interest rate retained earnings