Prof. Bryan Caplan

bcaplan@gmu.edu

http://www.gmu.edu/departments/economics/bcaplan

Econ 311

Fall, 1999

Week 5: Savings and Investment

1. The Market for Loanable Funds
1. In the market for loanable funds, people essentially exchange present goods for future goods. People sell some consumption now to buy more consumption later, or buy some consumption now by selling some consumption later.
2. Challenge: Analyze supply and demand in the market for present goods. Put Q of present goods lent on x-axis, and real interest rate on the y-axis. (Recall distinction between real and nominal rates).
3. Supply of present goods: Determined by amount of present goods (in dollar terms) people are willing to lend out at different interest rates. At an interest rate of 0%, people are lending \$100 now for \$100 in the future (say a year from now). At an interest rate of 10%, people are lending \$100 now for \$110 a year from now. Should have usual upward slope.
4. Demand for present goods: Determined by amount of present goods people want to borrow at different interest rates.
5. As usual, look at the intersection of S&D for determination of real interest rate. At higher rates, there is an excess supply of present goods; at lower rates, there is excess demand for present goods.
6. Nominal interest rates are just real income rates plus the expected inflation rate. Note that nominal interest rates will always be positive. (Why?)
2. Consumption Smoothing and the Permanent Income Hypothesis
1. How do people use the market for loanable funds? The central function is to "smooth consumption" over time.
2. Think of your whole lifespan. There are some parts of your life where your income will be especially high, and others where your income would be especially low. Without a market for loanable funds, there would be little you could do about this.
3. But with the market for loanable funds, you can sell present goods (lend/invest) when you are relatively rich, and buy present goods (dissave/borrow) when you are relatively poor.
4. Simple example: Suppose your weekly groceries are stolen out of your car. You could just fast for a week; or you could buy more groceries by implicitly selling a little bit of your future income.
5. More generally: People tend to borrow a lot and save little during their low-income periods - youth and old age. And they save a lot and borrow little during their high-income periods - middle-age.
6. This idea is also known as the "permanent income hypothesis." The claim is that people consume based on their long-run or "permanent" income, not their current income.
3. Present Discounted Values and Investing
1. Some lending is for purposes of consumption, but other times lending goes into productive investment.
2. When people calculate what to invest in, the interest rate is of supreme importance. You can imagine investors choosing between two options:
1. Lending at the usual market interest rate.
2. Investing in a project that will have a future reward.
3. How do they make this choice? Essentially they calculate which option has the higher rate of return. How do they do this? By computing their projects' present discounted value.
4. Key idea behind PDV: How much is \$170 to be paid 1 year in the future worth now? Well, how much money would you need to invest now at the market interest rate to have \$170 1 years from now? Just \$170/(1+i). How about five years from now? \$170/(1+i)5
5. Once you have this key idea, you can do similar calculations for a whole stream of payments, positive AND negative. For example, what is the PDV of losing \$100 this year, then losing \$50 more next year, then earning \$100 a year later, then earning nothing for two years, then earning \$80? PDV=-\$100-\$50/(1+i)+ \$100/(1+i)2+ \$0/(1+i)3+\$0/(1+i)4+\$80/(1+i)5.
6. To determine whether a project is worth undertaking, investors can just compute the PDV of the sum of all losses and gains associated with the project. If a project has a positive PDV, its return is higher than the market interest rate; if its PDV is negative, its return is lower; if its PDV is zero, its return equals the market return.
4. Investments: Physical Capital, Human Capital, and Ideas
1. Notice that the lower the interest rate is, the more likely a project with gains far out in the future is to have a positive PDV. If interest rates are very high, in contrast, only projects with immediate payoffs will be worth doing.
2. Thus, the higher interest rates are, the more people will want to focus on short-term projects; the lower interest rates are, the more they will want to focus on long-term projects.
3. There are many different kinds of projects to invest in. PDV calculations can be made for all of them.
1. Physical capital
2. Human capital
3. Ideas
4. Example: Calculate the PDV of going to college and getting a degree.
5. Investments: Private vs. Social Returns
1. Normally we think of investments - in physical capital, human capital, or ideas - as increasing productivity. By investing, people make resources more productive.
2. But there is an important distinction between private and social returns from investment. Sometimes the investor does not get all of the benefits he creates; other times the investor does not pay all of the costs.
3. Many people see invention as a case where social returns exceed private returns. The inventor of penicillin captures only a small fraction of the total benefit created, leading to under-investment in such inventions.
4. Government subsidies could conceivably correct for this problem, though they often redirect invention in unproductive directions.
5. Many see education in the same light, though it's unclear why. Others, including me, see education as an investment where social returns are much less than private returns. If education serves as a signal rather than increasing worker productivity, there is excess investment in education.
6. If this theory is right, then the efficient government response would be to TAX education. In actual practice, of course, most governments subsidize it. (Suggests that governments may intervene in the opposite of the efficient direction if they play any role at all...)
6. Basics of Financial Markets
1. The market for loanable funds is more than just banks; it includes all financial markets, including those for stocks, bonds, etc. These are all methods for people to trade present goods for future goods.
2. All financial assets have two basic features:
1. Return, the average rate of return on the investment.
2. Risk, the magnitude of dispersion around the mean.
3. Ex: T-Bills vs. stocks.
4. What determines the price of a financial asset? While there are complications, the most important determinant is the "fundamentals" of the asset: the sum of all the payments associated with the asset, discounted by the appropriate interest rate. The fundamental is just the PDV of an asset from the current date forward.
5. Ex: What is the fundamental of a bond that pays \$100 10 years from now?
6. Note that the terms in the PDV are never known with certainty. People have to guess at what both the numerators (payouts) and denominators (interest rates) will be. When new information comes in, asset prices change.
7. Critical insight: Assets' prices change as soon as the information arrives! If you know that something bad going to happen, everyone would sell unless the price fell to reflect it.
8. Implication: Asset prices should follow a "random walk": true NEWS that leads people to alter their estimates of assets' worth is by nature unpredictable.
9. For the most part, this random walk theory works empirically.
7. Fallacies
1. Under-consumption. Many see savings as a grave economic danger, and consumption as a great economic benefit. But as long as the interest rate clears the market for loanable funds, increased savings by some just opens up new consumption or investment possibilities for others. More savings has no necessary effect on AD.
2. Usury. Many people have seen interest as uniquely evil and exploitative; legal codes have often banned interest, fixing the legal rate at 0%. But a legal market for loanable funds still benefits both parties.
3. The folly of financial journalism: There are four standard financial market reports:
4.  Market Fell Today pessimism profit-taking Market Rose Today bargain-hunting optimism
5. This is not news, but mere labeling. The empirical fact is that financial markets largely follow a random walk, and there is no way to predict today's market performance from yesterday's.
8. Application: Is Your Portfolio Optimal?
1. The random walk and financial advice: Since markets follow a random walk, spending money on financial advisors is mostly a waste of money, as are trading expenses.
2. Principal of diversification: Buying small amounts of many assets allows you to reduce risk with little sacrifice of return. This is like doing a hundred small gambles instead of one big one: your average probably won't change, but your risks shrink drastically.
3. The equity premium puzzle: On average, the real return on stocks over bonds has been strangely large for a long time - more than it seems you would need to compensate for extra risk. Average real return on stocks is about 10%, compared to 2% on bonds, even though stocks almost always outperform bonds over the course of a decade.
4. Simple, free financial advice that follows: