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ECON 102.004 – Principles of Microeconomics

S&W, Chapter 9

Capital Markets

Instructor:

Mehmet S. Tosun, Ph.D.

Department of Economics

University of Nevada, Reno

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Lecture Outline

• Households’ saving decision

• Time value of money

• Income and substitution effects

• Firm’s demand for capital

• Education and human capital

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The Capital Market

• Where individuals, firms, and the government save and borrow money

• The savings decision is a choice between two goods: – goods today and goods in the future

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Present and Future Consumption (continued)

• Consume w during the working period or w(1+r) in retirement or any compensation in between.

• Consume less now or more later, but must wait to consume.

• The relative cost of consuming earlier is 1+r

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Example

• If the length of time between deposit and withdrawal of funds is 35 years and the real interest rate is 4%, then the amount received is

– principal (1 + .04)35 = 3.95

– A consumer receives $3.95 in 35 years for every $1 she deposits now.

• If the interest rate rises to 6%

– A dollar saved today will grow into $7.69 in 35 years

• This means when the interest rate rises today's consumption is more expensive relative to future consumption.

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The Time Value of Money

• Nominal interest rates are never negative.

• At an interest rate of 5%, $1 today is worth $1.05 next year: $1(1 + 0.5) = $1.05 = (1 + r).

– Future Value = Present Value *(1 + r)

• We can turn this around.

– $1 next year is worth less than $1 today since a value less than $1 will grow (at 5% interest) to exactly $1 next year.

– This value is the present value of receiving $1 next year and is equal to $1/(1.05) = $.95.

– Present Value = Future Value/(1 + r)

– The present value is the value in today's money of $1 in the future.

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The Time Value of Money

• Suppose an investment promises to give you the following returns:

$10,000 one year from now followed by

$15,000 two years from now and

$50,000 three years from now.

What is the most you should pay for this investment? (Notice that the total payments add up to $75,000 you should pay considerably less than this due to the time value of money)

Never pay more than the present discounted value of the investment. We calculate this on the next slide as $59,054.

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Saving and Changes in Interest Rates

• If the interest rate increases, the budget constraint rotates outward and gets steeper.

• As with any price change, an increase in the interest rate causes income and substitution effects.

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Savings and Interest Rates

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The Income and Substitution Effects for Savings

• For a saver the income and substitution effects work in opposite directions on savings.

– The income effect:

• When r rises, a saver is richer and can afford more present and more future consumption. When present consumption increases, saving falls.

– The substitution effect:

• When r rises, the price of present consumption increases relative to future consumption. Consumers reduce present consumption, so saving increases.

• Studies find that the substitution effect is stronger, so the supply of saving curve is upward sloping.

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Inflation and the Real Rate of Interest

• The nominal interest rate tells us how savings grow in terms of dollars.

• The real interest rate tells us how savings grow in terms of purchasing power.

• The real interest rate r is the nominal interest rate R adjusted for inflation.– r = R – r is a better measure of the rate of return on money since it

measures the rate of return in terms of constant purchasing power.

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Social Security and Savings

• Social Security

– Affects need to save and has lowered overall level of saving

• On the other hand, private saving schemes have grown over the last 50 years as Social Security has become more generous. Why?

– Increases in life expectancy have increased the need for retirement income faster than the generosity of Social Security.

• Age at which a worker qualifies to receive full Social Security benefits has increased from 65 years to 67 years.

– Consumers want to enjoy more consumption during retirement years.

– Young people are concerned their benefits will be cut so they save more during their working years.

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The Demand for Loanable Funds• Demand for funds is driven by firms that borrow savings to buy

capital goods, plants, and so on.• r is the price of loanable funds and also the price of capital goods.• Firms hire or buy capital and borrow funds until the last unit of

capital just pays for itself.• The product of the last unit of capital is the MPK, which is

downward sloping because capital is subject to diminishing returns.

• Firms borrow until MPK = the real interest rate.• Firms borrow until the real returns equal the real costs of

borrowing.

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The Supply and Demand for Loanable Funds

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The Supply and Demand for Loanable Funds• Suppose a new technology increases firms' demand for capital.• The demand for funds increases and its curve shifts right, and the interest rate rises.

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Behavioral Perspective on Saving (a)

• The basic consumption smoothing model suggests households should save during peak earning years so that at retirement earnings fall but not consumption.– Evidence: when people retire both earnings and

consumption fall.• They have not saved enough for retirement.

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Behavioral Perspective on Saving (b)

• Behavioral perspective on under-saving

– Lack of self-control

– For example: most smokers want to quit but say best time is tomorrow not today

• When tomorrow comes the best time to quit is still tomorrow and they never quit.

– Behavioral perspective is supported by fact that much of U.S. saving is “forced saving,” or automatic savings:

• employer set aside for worker’s pension

• homeowners build up equity in house as they pay off mortgage

• income tax withholding generates refunds

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Behavioral Perspective on Saving (c)

• High saving rates in some Asian countries (30 -- 40% savings rates) explained by:– cultural factors– family size– age distribution of population

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Behavioral Perspective on Saving (d)

• Behavioral insights may be especially useful in designing policies to affect savings.– Status quo effect suggests that the default

option on saving plans is important.• For 401(k) plans, if default is opt-in then people

may save more.

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Productivity (a)

• The output a firm or society produces depends on the number of hours worked and the productivity of those hours.

• Workers' productivity (and their wages) depend on education.

• Trade‑off: If in school, the student forgoes income or leisure in return for higher future income.

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Productivity (b)

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Human Capital (a)

• Human Capital– The costs of college include explicit outlays: tuition, room, board,

books, and caffeine.– They also include the opportunity costs of time spent in school:

forgone wages and leisure.– Investment in education is a form of human capital, similar to

physical capital.– The United States invests an enormous amount in human capital,

both publicly and privately.– The government alone spends a quarter of a trillion dollars a year

on education.– Economists estimate that three‑quarters of all capital is human

capital.

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Education Expenditures in OECD Countries

COUNTRIES

Annual Expenditure on Educational Institutions per student (2002)*

Annual Expenditure on Educational Institutions

per student relative to GDP per capita (2002)

Total Public Expenditure on Education as a

percentage of Total Public Expenditure (2002)

Total Public Expenditure on Education as a

percentage of GDP (2002)

Australia 19,665 23.65 10.6 3.7

Austria 28,373 31.42 7.6 3.8

Belgium 13,936 24.34 8.3 4.2

Denmark 15,730 26.18 8.7 4.8

France 20,402 24.76 7.7 4.1

Germany 21,458 26.84 6.4 3.1

Hungary 11,583 26.88 6.2 3.3

Ireland 15,883 16.27 9.2 3.1

Italy 14,799 28.08 7.2 3.5

Japan 13,069 24.02 8.0 2.7

Mexico 3,235 17.26 16.2 3.6

Netherlands 18,253 20.32 7.2 3.4

New Zealand 10,234 22.96 14.7 4.7

Norway 5,481 24.07 9.4 4.5

Poland 5,481 24.48 m 4.1

Portugal 11,861 31.51 9.2 4.3

Spain 10,601 22.85 7.5 3.0

Sweden 18,495 21.90 8.5 5.0

Switzerland 28,268 28.96 9.1 4.1

United Kingdom 11,655 20.16 9.0 3.7

United States 17,147 23.68 10.3 3.8

OECD Average 14,260 23.44 8.91 3.72

*In equivalent US dollars converted using PPPs for GDP, based on full time equivalentsSource: OECD Education at a Glance, 2005.

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