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Production, Saving, and Time. Production Cannot occur without prior saving Roundabout production Produce capital to increase productivity Requires saving Takes time Goods and services are not available from current production. Consumption, Saving, and Time. Consumers

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production saving and time
Production, Saving, and Time
  • Production
    • Cannot occur without prior saving
    • Roundabout production
      • Produce capital to increase productivity
    • Requires saving
      • Takes time
        • Goods and services are not available from current production
consumption saving and time
Consumption, Saving, and Time
  • Consumers
    • Positive rate of time preference
    • Willing to pay more to consume now
      • Impatience
      • Uncertainty
    • Interest
      • Reward for postponing consumption
consumption saving and time1
Consumption, Saving, and Time
  • Positive rate of time preference
    • Consumers value present consumption more than future consumption
    • People must be rewarded to postpone consumption
  • Interest rate
    • Interest per year as a percentage of the amount saved or borrowed
optimal investment
Optimal Investment
  • Specialization and exchange
    • Purchase capital
    • Borrow funds
  • Firms buy new capital goods
    • If they expect this investment to yield a higher return than other possible uses of their funds
optimal investment1
Optimal Investment
  • Expected rate of return on capital
    • Expected annual earnings divided by capital’s purchase price
  • Market interest rate
    • Opportunity cost of investing
  • Maximize profit
    • Increase investment as long as marginal rate of return > market interest rate
exhibit 1
Exhibit 1

Expected Rate of Return on Golf Carts and the Opportunity Cost of Funds


Expected rate

of return



Market rate

of interest

Interest rate (percent)











An individual firm invests in any project with an expected rate of return that exceeds the market interest rate. At an interest rate of 8 percent, Hacker Haven invests $15,000 in three golf carts.

optimal investment2
Optimal Investment
  • Downward-sloping demand curve for investment (individual industries)
    • More is invested when the opportunity cost of borrowing is lower
  • Investment demand curve for the entire economy
    • Downward sloping
the market for loanable funds
The Market for Loanable Funds
  • Demanders of loans (borrow)
    • Entrepreneurs
      • Start firms
      • Invest in physical and intellectual capital
      • Increase investment until
        • Expected marginal rate of return = market interest rate
    • Households
      • Present consumption
      • Invest in human capital
the market for loanable funds1
The Market for Loanable Funds
  • Demand for loanable funds
    • Negative relationship between
      • Market interest rate
      • Quantity of loans demanded
    • Declining marginal rate of return
    • Other things constant
      • Prices of other resources, technology
      • Expected rate of inflation, tax laws
      • Customs and conventions of the market
the market for loanable funds2
The Market for Loanable Funds
  • Supply of loanable funds
    • Banks = financial intermediaries
    • Positive relationship between
      • Market interest rate
      • Quantity of savings supplied
    • Interest rate = Reward for saving
the market for loanable funds3
The Market for Loanable Funds
  • Loanable funds market
    • Savers (suppliers of loanable funds)
    • And borrowers (demanders of loanable funds)
    • Come together to determine
      • Market interest rate
      • Quantity of loanable funds
exhibit 2
Exhibit 2

Market for Loanable Funds

Because of the declining expected rate of return on capital, the quantity of loanable funds demanded is inversely related to the interest rate. The market rate of interest, 8 percent, is found where the demand curve for loanable funds intersects the supply curve of loanable funds. An increase in the demand for loanable funds from D to D’ raises the market interest rate from 8 percent to 9 percent and increases the equilibrium quantity of loanable funds from $1.0 to $1.1 trillion



Interest rate (percent)







Loanable funds per year

(trillions of dollars)

why interest rates differ
Why Interest Rates Differ
  • Prime rate
    • Interest rate lenders charge their most trustworthy business borrowers
  • Collateral
    • Asset pledged by the borrower
    • Can be sold to pay off the loan in the event the borrower defaults
why interest rates differ1
Why Interest Rates Differ
  • Risk
    • The more valuable the collateral, the lower the interest rate
  • Duration of the loan
    • Interest rate increases with the duration of the loan
  • Administration costs
    • Decrease as size of the loan increases
  • Tax treatment
exhibit 3
Exhibit 3

Interest Rates Charged for Different Types of Loans

Interest rates are higher for riskier loans. Rates for home mortgages and new cars are relatively low because these loans are backed up by the home or car as collateral. Personal loans and credit card balances face the highest rates, because these loans are riskier—that is, the likelihood borrowers fail to repay the loans is greater and the borrower offers no collateral.

present value and discounting
Present Value and Discounting
  • Present value
    • Current value of payment(s) to be received in the future
  • Discounting
    • Converting future dollar amounts into present value
present value and discounting1
Present Value and Discounting
  • Present value one year hence
    • Amount received one year from now
      • Divided by (1+interest rate)
    • The higher the interest rate
      • The more any future payment is discounted
      • The lower its present value
present value and discounting2
Present Value and Discounting
  • Present value (PV) for payments in later years
    • Receive M dollars
    • t years from now
    • Interest rate i
    • Smaller for higher t
present value and discounting3
Present Value and Discounting
  • Present value of an income stream
    • Receive $100 next year
    • And $150 year after next
    • i=5%
present value and discounting4
Present Value and Discounting
  • Annuity
    • A given sum of money received each year for a specified number of years
  • Present value of an annuity
    • Perpetuity – if continues indefinitely
    • Present value of receiving M dollars each year forever
  • Entrepreneur
    • Comes up with an idea
    • Turns that idea into a marketable product
    • Accepts the risk of success or failure
    • Claims any resulting profit or loss (residual claimant)
  • Entrepreneur
    • Have the authority to hire and fire the manager
    • Drive the economy forward
      • New products
      • Improve existing products
      • New production methods
      • New ways of doing business
  • Not entrepreneurs
    • Corporate inventors
    • Managers
    • Stockholders
exhibit 4
Exhibit 4

Source of U.S. Patents

corporate finance
Corporate Finance
  • Corporation
    • Owned by stockholders
    • Owns property
    • Earns profit
    • Sue or get sued
    • Incur debt
corporate stock
Corporate Stock
  • Corporations fund investment
    • Issue and sell stock
    • Retain some of their profits
    • Borrow
  • Initial public offering (IPO)
    • Initial sale of corporate stock to the public
  • Corporate stock
    • Certificate reflecting part ownership of a corporation
corporate stock1
Corporate Stock
  • Corporations pay
    • Corporate income taxes on any profit
    • Dividends to shareholders
  • Dividends
    • After-tax corporate profit paid to stockholders
    • Rather than retained by the firm and reinvested
retained earnings
Retained Earnings
  • Retained earnings
    • After-tax corporate profit reinvested in the firm
    • Rather than paid to stockholders as dividends
    • Help the firm grow
corporate bonds
Corporate Bonds
  • Corporations borrow
    • Bank loan
    • Issue and sell bonds
  • Bond
    • Certificate reflecting a firm’s promise
      • To pay the lender periodic interest
      • And to repay the borrowed sum of money on the designated maturity date
    • Less risky than stocks
securities exchange
Securities Exchange
  • Securities market
    • Stocks and bonds
    • Secondary market for securities
      • Enhance liquidity
    • Hedge funds
    • Determine the current value of a corporation
    • Allocate funds more readily to successful firms than to firms in financial difficulty