HE191

Principles of Economics
Lecture 9

Chapters 26 and 27
Principles of Economics, Fourth Edition
N. Gregory Mankiw
 In this lecture, look for the answers to
these questions:
„ What are the main types of financial institutions in the U.S.
economy, and what is their function?
„ What are the three kinds of saving?
„ What’s the difference between saving and investment?
„ How does the financial system coordinate saving and
investment?
„ How do govt policies affect saving, investment, and the
interest rate?
„ What is “present value”? How can we use it to compare
sums of money from different times?
„ Why are people risk averse? How can risk-averse people
use insurance and diversification to manage risk?
„ What determines the value of an asset? What is the
“efficient markets hypothesis”?
 Financial Institutions
„ The financial system: the group of institutions that
helps match the saving of one person with the investment
of another.
„ Financial markets: institutions through which savers
can directly provide funds to borrowers. Examples:
„ The Bond Market.
A bond is a certificate of indebtedness.
„ The Stock Market.
A stock is a claim to partial ownership in a firm.
„ Financial intermediaries: institutions through which
savers can indirectly provide funds to borrowers.
Examples:
„ Banks
„ Mutual funds – institutions that sell shares to the public
and use the proceeds to buy portfolios of stocks and bonds
Different Kinds of Saving
Private saving
= The portion of households’ income that is not used for
consumption or paying taxes = Y – T – C
Public saving
= Tax revenue less government spending = T – G
National saving
= private saving + public saving
= (Y – T – C) + (T – G) = Y – C – G
= the portion of national income that is not used for
consumption or government purchases
Saving and Investment

Recall the national income accounting identity:

Y = C + I + G + NX
For the rest of this chapter, focus on the
closed economy case:
Y=C+I+G national saving
Solve for I:
I = Y – C – G = (Y – T – C) + (T – G)

Saving
Saving == investment
investment in
in aa closed
closed economy
economy
Budget Deficits and Surpluses

Budget surplus
= an excess of tax revenue over govt spending
= T–G
= public saving

Budget deficit
= a shortfall of tax revenue from govt spending
= G–T
= – (public saving)
The Meaning of Saving and Investment

„ Private saving is the income remaining after

households pay their taxes and pay for
consumption.
„ Examples of what households do with saving:
„buy corporate bonds or equities
„purchase a certificate of deposit at the bank
„buy shares of a mutual fund
„let accumulate in saving or checking accounts
The Meaning of Saving and Investment

„ Investment is the purchase of new capital.

„ Examples of investment:
„ General Motors spends $250 million to build
a new factory in Flint, Michigan.
„ You buy $5000 worth of computer equipment for
your business.
„ Your parents spend $300,000 to have a new
house built.
Remember:
Remember: In
In economics,
economics, investment
investment is
is NOT
NOT
the
the purchase
purchase of
of stocks
stocks and
and bonds!
bonds!
The Market for Loanable Funds

„ A supply-demand model of the financial system.

„ Helps us understand
„ how the financial system coordinates
saving & investment
„ how govt policies and other factors affect saving,
investment, the interest rate
Assume: only one financial market.
„ All savers deposit their saving in this market.
„ All borrowers take out loans from this market.
„ There is one interest rate, which is both the return
to saving and the cost of borrowing.
The Market for Loanable Funds

The supply of loanable funds comes from

saving:
„Households with extra income can loan it out
and earn interest.
„Public saving, if positive, adds to national
saving and the supply of loanable funds.
If negative, it reduces national saving and the
supply of loanable funds.
The Slope of the Supply Curve

Interest An increase in
Rate Supply the interest rate
makes saving
6% more attractive,
which increases
the quantity of
3% loanable funds
supplied.

60 80 Loanable Funds
($billions)
The Market for Loanable Funds

The demand for loanable funds comes from

investment:
• Firms borrow the funds they need to pay for
new equipment, factories, etc.
• Households borrow the funds they need to
purchase new houses.
The Slope of the Demand Curve

Interest
A fall in the interest
Rate
rate reduces the cost
7% of borrowing, which
increases the quantity
of loanable funds
4% demanded.

Demand

50 80 Loanable Funds
($billions)
 Equilibrium

The interest rate

Interest
Rate Supply adjusts to equate
supply and demand.
The eq’m quantity
5% of L.F. equals
eq’m investment
and eq’m saving.
Demand

60 Loanable Funds
($billions)
Policy 1: Saving Incentives

Interest Tax incentives for

Rate S1 S2 saving increase the
supply of L.F.

5% …which reduces the

4% eq’m interest rate and
increases the eq’m
D1 quantity of L.F.

60 70 Loanable Funds
($billions)
 Policy 2: Investment Incentives

Interest An investment tax

Rate S1
credit increases the
6% demand for L.F.

5% …which raises the

eq’m interest rate and
D2 increases the eq’m
D1 quantity of L.F.

60 70 Loanable Funds
($billions)
Budget Deficits, Crowding Out,
and Long-Run Growth
„ Our analysis: increase in budget deficit causes
fall in investment.
The govt borrows to finance its deficit,
leaving less funds available for investment.
„ This is called crowding out.
„ Recall from the preceding chapter: Investment
is important for long-run economic growth.
Hence, budget deficits reduce the economy’s
growth rate and future standard of living.
So,
„ Like many other markets, financial markets are governed
by the forces of supply and demand.
„ One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
„ Financial markets help allocate the economy’s scarce
resources to their most efficient uses.
„ Financial markets also link the present to the future:
Savers can convert current income into future purchasing
power, and borrowers to acquire capital to produce goods
and services in the future.
„ Participants in the financial market make decisions
regarding the allocation of resources over time and the
handling of risk.
„ Finance is the field that studies such decision making.
Present Value: The Time Value of Money

„ To compare a sums from different times, we

use the concept of present value.
„ The present value of a future sum: the
amount that would be needed today to yield
that future sum at prevailing interest rates.
„ Related concept:
The future value of a sum: the amount the
sum will be worth at a given future date, when
allowed to earn interest at the prevailing rate.
EXAMPLE 1: A Simple Deposit

„ Deposit $100 in the bank at 5% interest.

What is the future value (FV) of this amount?
„ In N years, FV = $100(1 + 0.05)N
„ In three years, FV = $100(1 + 0.05)3 =
$115.76
„ In two years, FV = $100(1 + 0.05)2 =
$110.25
„ In one year, FV = $100(1 + 0.05) = $105.00
EXAMPLE 1: A Simple Deposit

„ Deposit $100 in the bank at 5% interest.

What is the future value (FV) of this amount?
„ In N years, FV = $100(1 + 0.05)N
„ In this example, $100 is the present value (PV).
„ In general, FV = PV(1 + r )N
where r denotes the interest rate (in decimal form).
„ Solve for PV to get: PV FV/(1 ++ rr ))NN
PV == FV/(1
EXAMPLE 2: Investment Decision

Present
Present value
value formula:
formula: PV FV/(1 ++ rr ))NN
PV == FV/(1

„ Suppose r = 0.06.
Should General Motors spend $100 million to
build a factory that will yield $200 million in ten
years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.06)10 = $112 million
Since PV > cost of factory, GM should build it.
EXAMPLE 2: Investment Decision
„ Instead, suppose r = 0.09.
Should General Motors spend $100 million to build
a factory that will yield $200 million in ten years?
Solution:
Find present value of $200 million in 10 years:
PV = ($200 million)/(1.09)10 = $84 million
Since PV < cost of factory, GM should not build it.

present
present value
value helps
helps explain
explain why
why
investment
investment falls
falls when
when the
the interest
interest rate
rate rises
rises
Compounding

„ Compounding: the accumulation of a sum

of money where the interest earned on the
sum earns additional interest
„ Because of compounding, small differences in
interest rates lead to big differences over
time.
„ Example: Buy $1000 worth of Microsoft
stock, hold for 30 years.
If rate of return = 0.08, FV = $10,063
If rate of return = 0.10, FV = $17,450
Risk Aversion

„ Most people are risk averse – they dislike

uncertainty.
„ Example: You are offered the following gamble.
Toss a fair coin.
„ If heads, you win $1000.
„ If tails, you lose $1000.
Should you take this gamble?
„ If you are risk averse, the pain of losing $1000
would exceed the pleasure of winning $1000,
so you should not take this gamble.
Managing Risk With Insurance

„ How insurance works:

A person facing a risk pays a fee to the
insurance company, which in return accepts
part or all of the risk.
„ Insurance allows risks to be pooled,
and can make risk averse people better off:
E.g., it is easier for 10,000 people to each
bear 1/10,000 of the risk of a house burning
down than for one person to bear the entire
risk alone.
Two Problems in Insurance Markets
1. Adverse selection: A high-risk person benefits
more from insurance, so is more likely to
purchase it.
2. Moral hazard: People with insurance have less
incentive to avoid risky behavior.
„ Insurance companies cannot fully guard against
these problems, so they must charge higher
prices.
„ As a result, low-risk people sometimes forego
insurance and lose the benefits of risk-pooling.
Measuring Risk

„ We can measure risk of an asset with the

standard deviation, a statistic that
measures a variable’s volatility – how likely it
is to fluctuate.
„ The higher the standard deviation of the
asset’s return, the greater the risk.
Reducing Risk Through Diversification

„ Diversification reduces risk by replacing a

single risk with a large number of smaller,
unrelated risks.
„ A diversified portfolio contains assets whose
returns are not strongly related:
„ Some assets will realize high returns,
others low returns.
„ The high and low returns average out,
so the portfolio is likely to earn
an intermediate return more consistently
than any of the assets it contains.
Reducing Risk Through Diversification

„ Diversification can reduce firm-specific risk,

which only a single company.
„ Diversification cannot reduce market risk,
which affects all companies in the stock market.
Reducing Risk Through Diversification
Standard dev of portfolio return

50 Increasing
Increasing the
the
number
number ofof stocks
stocks
40
reduces
reduces firm-specific
firm-specific
30 risk.
risk.

20 But
But
market
market
10 risk
risk
remains.
remains.
0
0 10 20 30 40
# of stocks in portfolio
The Tradeoff Between Risk and Return

„ One of the Ten Principles from Chapter 1:

People face tradeoffs.
„ A tradeoff between risk and return:
Riskier assets pay a higher return, on average,
to compensate for the extra risk of holding them.
„ E.g., over past 200 years, average real return on
stocks, 8%. On short-term govt bonds, 3%.
The Tradeoff Between Risk and Return

„ Example:
Suppose you are dividing your portfolio between
two asset classes.
„ A diversified group of risky stocks:
average return = 8%, standard dev. = 20%
„ A safe asset: return = 3%, standard dev. = 0%
„ The risk and return on the portfolio depends on
the percentage of each asset class in the
portfolio…
The Tradeoff Between Risk and Return

Increasing
Increasing
the
the share
share ofof
stocks
stocks in
in the
the
portfolio
portfolio
increases
increases
the
the average
average
return
return but
but
also
also the
the risk.
risk.
Asset Valuation

„ When deciding whether to buy a company’s stock,

you compare the price of the shares to
the value of the company.
„ If share price > value, the stock is overvalued.
„ If price < value, the stock is undervalued.
„ If price = value, the stock is fairly valued.

„ It’s easy to look up the price.

But how does one determine the stock’s value?
Asset Valuation

„ Value of a share
= PV of any dividends the stock will pay
+ PV of the price you get when you sell the share
„ Problem: When you buy the share, you don’t
know what future dividends or prices will be.
„ One way to value a stock: fundamental
analysis, the study of a company’s accounting
statements and future prospects to determine its
value
The Efficient Markets Hypothesis

„ Efficient Markets Hypothesis: the theory that

each asset price reflects all publicly available
information about the value of the asset
„ Mutual fund managers
„ use fundamental analysis to assess value of all
publicly traded companies
„ buy shares when price < value,
sell shares when price > value
„ continuously monitor and act on any news
that affects the valuation of any stock
The Efficient Markets Hypothesis

„ Stock prices determined by supply & demand.

In equilibrium,
„ the number of people who believe a stock is
overvalued exactly balances the number who
believe it to be undervalued
„ the typical person perceives all stocks fairly
valued
Informational Efficiency
„ According to the Efficient Markets Hypothesis,
the stock market is informationally efficient:
each stock price reflects all available information about
the value of the company.
„ When good news about a company’s prospects
becomes public, the value of the company rises, so
money managers buy lots of shares until the price
rises to the new, higher value.
„ When bad news becomes public, the value of the
company falls, so money managers sell the shares
until their price falls by the same amount.
„ At any moment, a stock price is the market’s best guess
of the company’s value based on all available information.
Index Funds vs. Managed Funds

„ An index fund is a mutual fund that buys all the

stocks in a given stock index.
„ An actively managed mutual fund aims to buy
only the best stocks.
„ The efficient markets hypothesis implies that it is
impossible to consistently “beat the market.”
„ If true, the returns on actively managed funds
should not consistently exceed the returns on
index funds.
„ In fact, most actively managed funds perform
worse than index funds (and have higher fees).
Market Irrationality

„ Economists have argued that stock price

movements are partly psychological:
„ 1930s: John Maynard Keynes said stock prices
are driven by investors’ “animal spirits” –
irrational waves of pessimism and optimism
„ 1990s: Fed Chair Alan Greenspan said the stock
boom reflected “irrational exuberance”
„ Speculative “bubbles” may occur:
Someone may be willing to pay more than she
thinks a stock is worth if she believes she will be
able to sell it for even more in the future
Market Irrationality
„ Economists and market watchers debate the
importance of departures from rationality.
„ It’s true that stock prices often move in ways that
are hard to explain rationally.
„ Yet, it’s impossible to know what price
movements are “rational.”
„ And if many investors behaved irrationally, there
would be profit opportunities for rational
investors. Yet, beating the market is nearly
impossible.