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Chapter 4

Chapter 4. Understanding Interest Rates. Administrative Details. Next week we will run the interest rate experiment from aplia.com. There is a homework assignment that is due before next weeks class to prepare you for the experiment. Requires bringing a laptop computer to class.

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Chapter 4

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  1. Chapter 4 Understanding Interest Rates

  2. Administrative Details. • Next week we will run the interest rate experiment from aplia.com. • There is a homework assignment that is due before next weeks class to prepare you for the experiment. • Requires bringing a laptop computer to class. • Requires installation of the CSUN VPN on your laptop. • http://csunecon.com/?p=63

  3. The Importance of Financial Markets • Financial Markets (or the ability to borrow and lend) improves welfare in 2 ways. • Efficiently allocates investible funds among alternative investments. • Provide the ability to borrow and lend money allows people to adjust spending patterns over time. • Therefore, access to Financial Markets makes people better off.

  4. Gravina Island Bridge projected to cost about $500 million dollars connecting Gravina Island (pop. 50) to the mainland.

  5. F-22, 28 billion to develop. Cost $361,000,000 dollars per aircraft F-35, $282,000,000,000 total program cost. Cost $92 million per aircraft. MQ-9 Cost $12 million per aircraft.

  6. Military Expenditures. U.S. military spending is large compared to GDP and is enormous compared to other countries. “As many frustrated Americans who have joined the Tea Party realize, we cannot stand against big government at home while supporting it abroad. We cannot talk about fiscal responsibility while spending trillions on occupying and bullying the rest of the world. We cannot talk about the budget deficit and spiraling domestic spending without looking at the costs of maintaining an American empire of more than 700 military bases in more than 120 foreign countries. We cannot pat ourselves on the back for cutting a few thousand dollars from a nature preserve or an inner-city swimming pool at home while turning a blind eye to a Pentagon budget that nearly equals those of the rest of the world combined.” Ron Paul

  7. The views from atop Los Angeles Unified School District's downtown headquarters are sweeping: Disney Hall, the Music Center complex, iconic high-rise buildings that make up the L.A. skyline. Inside the 29-story building, more than 3,400 employees filter through LAUSD's main offices every week. The triangular, 928,000-square-foot tower at 333 S. Beaudry Ave. had historically been difficult to lease while owned by Bank of America. It was purchased and renovated by LAUSD in 2001 for $154 million. But even today, according to a top LAUSD official, the building seems too ostentatious in light of budget cuts and other financial issues the country's second-largest public school district is grappling with. But Superintendent David Brewer III maintained that Beaudry should not be viewed as a typical corporate building, saying it lacks the granite, fine wood and other trappings of some of downtown's more grandiose skyscrapers. "It's pretty austere," Brewer said, adding that his own offices are adequate. He said that while $154 million might seem pricey for the purchase and rehabilitation of the building, it is far less than the cost of leasing space downtown for all of the district's administrators and support staff. Brewer said he hopes the building eventually will come to be seen as a symbol of efficiency as he reduces the size of the central administration and consolidates leased space at other downtown locations into Beaudry. "It will be a symbol of success versus a symbol of bureaucracy. We'll consolidate all in one and save a fortune, and that's the ultimate in decentralization .

  8. Efficient Allocation of Investible Funds Interest Rate 20% 15% Suppose there are 6 potential projects that could be funded and the expected rates of return and required investments are given in the table above. If there was a pool of 53 billion dollars of investible funds, what is an efficient allocation of funds among the potential projects, i.e. what allocation will maximize social welfare. 10% 5% 2% Demand (borrowers) 1% 20 30 45 53 58 68

  9. Proposed 1.2 billion dollar 72,000 seat NFL stadium next to the convention center. Supported by 350 million dollars of government bonds to finance construction with AEG promising to repay the bonds with revenue from the stadium.

  10. 3808 Woolwine Dr, Los Angeles. 2145 sq. ft. house built in 1932. Was worth approximately $600K in 2006. Repossessed in Nov. 2010 with a mortgage of $298,199. Sold in Feb. 2011 for 170,000. On the market Sept. 2011, now for $338K.

  11. Proposed Keystone Pipeline. Estimated cost 13 billion dollars.

  12. Obama Officials Defend Solar Loan to Bankrupt Firm as Emails Show Past Concerns Obama administration officials on Wednesday defended a $528 million loan to a solar-panel company that went bankrupt this month, claiming the firm fell victim to global economic trends but that federal investment in alternative energy must continue.  The testimony came as Republican and Democratic lawmakers raised sharp questions about the decision that ultimately left taxpayers on the hook for millions, and as newly released emails show administration officials were raising doubts about the loan proposal to Solyndra months before it was finalized.  But emails released by the House Energy and Commerce Committee show that the relevant credit committee decided "not to engage in further discussions with Solyndra" in the final days of the Bush administration. After the change in administration, officials restarted the loan review process for Solyndra.  One Republican aide said the emails released as part of that probe show the White House was more concerned with press events surrounding the loan than the soundness of Solyndra. The aide said "corners were cut."  The emails at least show budget analysts felt rushed by the White House to review the loan guarantee in time for an announcement by Vice President Biden in September 2009.  The concerns flared in August 2009, when staff with the Energy Department wrote of a "major outstanding issue," relating to the project's solvency. They noted an estimate said the project would run out of cash in September 2011.  But other administration officials presumed the parent company, as well as private investors, would cushion the project and ensure its completion.  The company filed for bankruptcy this month. President Obama visited Solyndra in May 2010, heralding the company as “leading the way toward a brighter and more prosperous future.” He also cited it as a success story from the government’s $787 billion economic stimulus package. “Less than a year ago, we were standing on what was an empty lot.  But through the Recovery Act, this company received a loan to expand its operations,” Obama said at the time. “This new factory is the result of those loans.” In 2009, the Obama administration fast-tracked Solyndra’s loan application, later awarding it $535 million in guarantees from the stimulus funds. The deal later came under scrutiny from independent government watch dogs and members of Congress, which said the administration had bypassed key taxpayer protections in a rush to approve the funds — claims the administration has denied.

  13. Efficient Allocation of Investible Funds Interest Rate 20% 15% The efficient allocation, i.e. the allocation that would maximize social welfare, would be to fund the projects with the highest rate or return and leave the ones with lower (or negative) rates of return unfunded. In a free or unregulated market, this is exactly the allocation that would occur because people investing their own money would seek out the projects with the highest returns. Adding uncertainty into the mix would not change this result. Supply 10% 5% 2% Demand 1% 20 30 45 53 58 68

  14. Efficient Allocation of Investible Funds Interest Rate 20% 15% Suppose a different allocation occurred, possibly due to government intervention that directed loanable funds to projects that would not be funded in a free unregulated market. What effect would this have on social welfare? For instance, suppose money was taken from project 2 and diverted to project 6? Net loss of 14%*10 billion = $1.4 billion. Supply 10% 5% 2% Demand 1% 20 30 45 53 58 68

  15. Free Markets and Efficient Allocations • Generally speaking, loanable funds will be allocated efficiently if decisions are left in the hands of those who will be rewarded financially if funds are allocated correctly and penalized financially if funds are incorrectly allocated. • This does not mean that every investment funded by private investors will be profitable or able to repay money borrowed because no one can foresee the future. • Private investors will make mistakes but when they do, they alone will suffer the consequences. • Gross misallocation of loanable funds generally occur when the person making the decision about whom to lend to is not rewarded for choosing wisely and not punished for choosing poorly.

  16. Examples of Misallocation of Loanable Funds Reducing Social Welfare. • Spanish promotion of green energy. • http://www.juandemariana.org/pdf/090327-employment-public-aid-renewable.pdf • Spent $774,000 for each “green job” created. • Destroyed 2.2 jobs for each “green job” created. • Increased the price of electricity costing consumer and driving businesses that are heavy electricity users to other countries. • Chinese promotion of green energy. • http://www.nytimes.com/2010/09/09/business/global/09trade.html • In both cases, if producing electricity using wind or the sun was the lowest cost method of producing power, no government subsidy would be necessary to “promote” the industry. • If a solar panel costs $100,000 to produce and produces a flow of electricity worth $50,000 over its life, subsidizing its production reduces social welfare. • If a solar panel costs $100,000 to produce and produces a flow of electricity worth $200,000 over its life, no subsidy is necessary. • The main beneficiary of the subsidies are purchasing countries like the U.S.

  17. Examples of Misallocation of Loanable Funds Reducing Social Welfare. • Municipal Finance of Sports Stadiums. • http://online.wsj.com/article/SB10001424052748704269204575270802154485456.html • History of government financing public sports stadiums is that the debt eventually has to be repaid with general tax revenue rather than revenue from the stadium. • If the stadium offered and expected return above the market rate of interest, no public financing would be necessary. • Explanations for the interference in the market: • Stupidity. • Corruption. • Redistribution of Income.

  18. Efficient Allocation of Investible Funds Interest Rate 20% 15% Any interference in the allocation of funds that occurs in an unregulated market reduces social welfare. And redistributes income from one group to another group. Supply 10% 5% 2% Demand 1% 20 30 45 53 58 68

  19. The Inter temporal Budget Constraint If the person engaged in zero consumption today, how much consumption could he have in the future? Use Budget line and IC analysis to show how access to financial markets makes people better off by allowing them to control when and how much they consume over time. Consider a person who will make $50,000 today and $50,000 in the future. What does his budget line look like if the interest rate is 10%? Consumption in the future If a person borrowed $10K today at 10% interest he would owe $11K in the future. What are the endpoints of the budget line and what behavior do the represent? Suppose a person wanted to consume $60K today. Starting point without financial markets. $50K If the person engaged in zero consumption in the future, how much consumption could he engage in today? $39K $50K $60K Consumption today

  20. The inter temporal budget constraint shows combinations of consumption now and in the future that are attainable with a certain flow of income and access to financial markets, i.e. the ability to borrow and lend money at the current interest rate. The present value of the person’s income stream is the horizontal intercept, i.e. what is the maximum amount of consumption the person given his stream of income and access to financial markets, i.e. the ability to borrow and/or lend at market interest rate. The future value of a person’s income stream is the vertical intercept, i.e. what is the maximum amount of consumption he could engage in given his stream of income and access to financial markets. Consumption tomorrow Future Value = 50,000 (1.1) + 50,000= $105,000 $105K Starting point without financial markets. Present Value =50,000/(1.1)+ 50,000= 45454.54+ 50,000= 95,454.54 $50K $50K Consumption today $95,454.54

  21. If he tried to lend money could he spend more or less in the future if the interest rate is higher? Suppose interest rates increase to 20%. How would this affect the inter temporal budget constraint and the present and future value of his income stream? Consumption tomorrow 50,000 +(50,000)(1.2)=110,000 $105K If tried to borrow money could he borrow more or less if the interest rate is higher? Starting point without financial markets. $50K 50,000 +(50,000)/(1.2)=91,666.67 $50K Consumption today $95,454.54

  22. The Bond Market and Direct Finance. Consumption tomorrow Discount Bond I will pay you $10 in the future. A Discount Bond is piece of paper promising to pay a certain amount of money at a certain future date. If a person sells a discount bond he is borrowing money. If a person buys a discount bond . Suppose this person bought 50 discount bonds for $8 each. What is the interest rate? 25% Where on the inter temporal budget constraint will he be? Spend $400 on bonds today and receives $500 in the future. $50,500 $50K $50K Consumption today $49,600

  23. What will the intertemporal budget constraint look like if the person earns 50K today and expects to earn 50K in the future? Consumption tomorrow Future Value = 50,000 (1.1) + 50,000= $105,000 Suppose policy makers could convince this person that his income in the future would be 75K in the future. What effect would this have on his inter-temporal budget constraint? New budget constraint $105K Starting point without financial markets where current income is $50K and future income is $75K $75K Starting point without financial markets. Present Value =50,000/(1.1)+ 50,000= 45454.54+ 50,000= 95,454.54 $50K $50K Consumption today $95,454.54

  24. Indifference Curves Indifference curves capture a person ‘s tastes and preferences, i.e. how much relative enjoyment he gets from consuming different goods. Any particular indifference curve shows combinations of two goods that give the person equal utility or, stated alternatively combinations of two goods that a person doesn’t care which he receives. Comparing indifference curves, the person is always happier if he could move to a consumption bundle that is on a higher IC, i.e. farther out from the origin. Any combination of 2 goods on IC2 is preferred over any combination on IC3. Good A Bundle Y is preferred over Bundle X because Y has the same amount of good B and more good A Y IC2 X IC1 Any combination of 2 goods on IC1 give equal levels of utility. Good B

  25. Indifference Curves Income How would you describe the movement from X to Y? How would you describe the movement from X to Y? Nissan Cube, $15,000 X Y Which point is the Cube and which is the Fit? IC2 IC1 Honda Fit, $17,000 Automobiles

  26. Indifference Curves and Equilibrium Income The person chooses the point on the inter-temporal budget constraint which is on the highest indifference curve. Y is preferred to X because IC2 is farther out from the origin than IC1. X Y IC2 IC1 Automobiles

  27. Indifference Curves and Equilibrium Consider the indifference curves of two people who both make 50K today and expect to make 50K in the future whose IC’s are depicted below. Which person is going to be a net borrower today and which person will be a net saver today? Consumption tomorrow $105K Blue will be a borrower and red will be a saver. Starting point. Moving from the starting point to here, is the person a net borrower or net lender? Will he buy or sell bonds? $50K $50K Consumption today $95,454.54

  28. How will a decrease in current interest rates affect current consumption and net borrowing and lending or stated alternatively, if the Federal Reserve followed a monetary policy which lowered interest rates how would this affect an ongoing recession? The decrease in the interest rate will cause the inter temporal budget constraint to rotate. The present value of his income will increase. He will consume more now and less in the future. Consumption tomorrow $105K What effect will a reduction in interest rates have on a recession? Starting point. $50K $50K Consumption today $95,454.54

  29. New budget constraint where the person expects to earn more in the future Consider an economic policy which simply changes people’s expectations about the future. Consumption tomorrow Suppose policy makers could convince this person that his income in the future would be 75K in the future. What effect would this have on his inter-temporal budget constraint? $105K New equilibrium $75K $50K Starting point where the person earns and consumes 50K today and 50K in the future. $50K Consumption today

  30. New budget constraint where the person expects to earn more in the future Consider an economic policy which simply changes people’s expectations about the future. Consumption tomorrow What effect would this have on current consumption and current demand for goods and services? What effect would this have on the bond market, i.e. would the amount of net borrowing increase? Would interest rates rise or fall? $105K $75K New equilibrium $50K Starting point where the person earns and consumes 50K today and 50K in the future. People would increase current consumption by borrowing against the future income. This would increase the supply of bonds, lowering their price and increasing interest rates. $50K Consumption today

  31. Consider an economic policy which made people expect less income in the future. Consumption tomorrow $105K $75K $50K Starting point where the person earns and consumes 50K today and 50K in the future. $50K Consumption today

  32. Real and Nominal Interest Rates Nominal interest rate makes no allowance for inflation Real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing Ex ante real interest rate is adjusted for expected changes in the price level Ex post real interest rate is adjusted for actual changes in the price level

  33. Fisher Equation

  34. FIGURE 1 Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2008 What does it tell you about inflation that the nominal rate is above the real rate.? Sources: Nominal rates from www.federalreserve.gov/releases/H15. The real rate is constructed using the procedure outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function of past interest rates, inflation, and time trends and then subtracting the expected inflation measure from the nominal interest rate.

  35. Chapter 5 The Behavior of Interest Rates

  36. 2 Models Used to Predict and Understand Changes in Interest Rates • Basic supply and demand analysis in the bond market. • Liquidity Preference Model (Keynesian)

  37. Understanding What Causes Changes in Interest Rates. Use basic supply and demand analysis in the bond market. Assume that there is only one type of bond—a simple discount bond with a face value of $1000. The price of bonds determines the interest rate and the bond price is inversely related to interest rate. What happens when bond prices are below the equilibrium price. If the price of a discount bond with a face value of $1000 is $1000 then the interest rate is zero If the price of a discount bond with a face value of $1000 is $800 then $800 is being lent, $200 interest is being paid and the interest rate is 25%

  38. Understanding What Causes Changes in Interest Rates. • Suppose the demand for bonds increases? • Is this due to more people wanting to lend or borrow? • Lend. • At the current price ($850) is there excess demand or excess supply? • Excess demand. • What will happen to the price and quantity of bonds sold? • More bonds sold. • Higher price. • What happens to interest rates? • Interest rates fall.

  39. Understanding What Causes Changes in Interest Rates. • Suppose the supply for bonds increases? • Is this due to more people wanting to lend or borrow. • Borrow • At the current price ($850) is there excess demand or excess supply? • Excess supply. • What will happen to the price and quantity of bonds sold? • More bonds sold. • lower price. • What happens to interest rates? • Interest rates rise.

  40. Determining the Quantity Demanded of an Asset Analysis of changes in interest rates using The Supply and Demand for bonds requires identifying what causes shifts in the supply and demand curves and doing simple supply and demand analysis. List of factors that can affect the demand for bonds. Wealth: the total resources owned by the individual, including all assets Expected Return: the return expected over the next period on one asset relative to alternative assets Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets

  41. Theory of Asset (Bond) Demand Holding all other factors constant: The quantity demanded of an asset is positively related to wealth The quantity demanded of an asset is positively related to its expected return relative to alternative assets The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

  42. Summary Table 1 Response of the Quantity of an Asset Demanded to Changes in Wealth, Expected Returns, Risk, and Liquidity

  43. Supply and Demand for Bonds • At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship • At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship

  44. Market Equilibrium Occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price Bd = Bs defines the equilibrium (or market clearing) price and interest rate. When Bd > Bs , there is excess demand, price will rise and interest rate will fall When Bd < Bs , there is excess supply, price will fall and interest rate will rise

  45. Shifts in the Demand for Bonds Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right Expected Returns: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left Expected Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left Liquidity: increased liquidity of bonds results in the demand curve shifting right

  46. Summary Table 2 Factors That Shift the Demand Curve for Bonds

  47. FIGURE 2 Shift in the Demand Curve for Bonds

  48. Shifts in the Supply of Bonds Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right because the expected real rate of interest declines. Government budget: increased budget deficits shift the supply curve to the right

  49. Summary Table 3 Factors That Shift the Supply of Bonds

  50. FIGURE 3 Shift in the Supply Curve for Bonds

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