FIN 30220: Macroeconomic

Analysis

Capital Markets
Recall that production is a function of labor, capital and technology.

Y  F ( A, K , L)

Capital Markets determine investment, which affects the evolution of the

capital stock over time
Annual Depreciation Rate

K '  (1   ) K  I G

Purchases of New
Tomorrow’s
Capital
capital stock

Remaining
portion of current
capital stock
 t=0 The US Economy t=1

Output/Income Determined
Capital Stock = K Capital Stock = K'
Productivity = A Y  F ( A, K , L* ) Productivity = A'

w
p
s
l (NLI ) Y  C  I G  G  NX The labor market
Production is allocated to in t=1 begins
*
 w various uses
 
 p
l d ( A, K )

L*
L K '  (1   ) K  I G
Labor Markets New capital is
Determine added to existing
employment stock
 2010 The US Economy 2011

Private Nonresidential Fixed

GDP = $14,500B Private Nonresidential Fixed
Assets Assets

$16,946B $17,346B
2010
Consumption $10,200B
w
Investment $1,800B
p
l s (NLI )
Government $3,000B Total Employment
Net Exports -500B$
*
132M
 w w
 
p
 p
l d ( A, K ) K '  K   IG  K  l s (NLI )

L * L 2010  w
 
*

Current Capital $16,946  p

Total Employment
Depreciation $1,400B (8%) l d ( A, K )
130M
L
Gross Investment $1,800B
Net Investment $400B
L*
 How was our net investment of $400B financed?

w
p Gross Domestic Product = $14,500B
l s (NLI )
Net Factor Payments ($200B)

Gross National Product = $14,700B

l d ( A, K )
Depreciation/Indirect Taxes ($2,200)
L
130M
National Income = $12,500B
We used 130M people
and $16.9T worth of
private capital to produce
$14.5T in output!!
 Financial Markets allocate saving to finance borrowing

Saving
Households: $500B
$1,800B
Government
Business: $800B
Financial Markets Deficit
$1,400 B

S  CA  I N   G  T 
Current Account
-$500B Net Investment
$400B
 Financial
Markets
Commercial Banks accept
deposits from one group Investment Banks buy bonds
(savers) and lends those from one group (borrowers)
funds out to others and sell those bonds to
(borrowers) others (savers)

Real interest Bond Price

r rate PB
S I   G T 

r* PB*

I   G T 
S
S, I
S  I   G T  S  I   G T 
Bonds

Suppose that government
runs a large deficit. The
increase in the demand for
loanable funds should
rise...this increases the
interest rate
Financial
Markets The government borrows
money by selling bonds.
The increased supply of
bonds should lower bond
prices

r PB
S I   G T 

r* PB*

I   G T 
S
S, I
S  I   G T  S  I   G T 
Bonds
 Alexander Hamilton was appointed by George
Washington as the first Secretary of the Treasury
in 1789. The US government has had outstanding
debt securities in global financial markets ever
since.

As of February 2015, total debt of the US government was equal to

$18,141,000,000,000.00

$13,038,000,000,000.00 $5,103,000,000,000.00
Debt held by the public Intergovernmental Debt
(net debt) measures (one branch of
outstanding government government borrowing
securities in financial from another – not “real”
markets debt)
 US Government Securities can be broadly categorized marketable and
non-marketable

Marketable Debt includes all Non Marketable Debt includes all

Treasuries that can be resold after Treasuries securities that can’t be
their initial purchase. Virtually all traded after initial purchase
US debt is in marketable
securities

Bills (< 1 year maturity) Savings Bonds

Notes (1- 10 year maturity) State and Local Government Series
(Slugs)
Bonds ( > 10 year maturity)
Rural Electrification Administration
Inflation Indexed Notes/Bonds series
 Treasury Bills make one payment of principal upon maturity. Consider a 90
Day T-Bill with a face value of $1,000 selling for $997

today 90 days

Pay $997 Receive $1,000

What is your (annualized) return on the bond?

Bond Equivalent Yield

 FV  P  365   $1,000  $997  365 

BEY     *100    *100  1.22%
 P  n   $997  90 
Discount Yield

 FV  P  360   $1,000  $997  360 

DY     *100    *100  1.20%
 FV  n   $1000  90 
 We could do the same calculation in reverse. Consider a 90 Day T-Bill with a
face value of $1,000

today 90 days

Pay Price P Today Receive $1,000

Suppose you required a 2% annualized return (Bond Equivalent Yield) . What

would you be willing to pay?

 FV   2  90 
P  i    .0049
1 i   100  365 

 $1,000 
 BEY  n  P   $995.12
i    1.0049 
 100  365  ( 995 4/32)
 We could do the same calculation in reverse. Consider a 90 Day T-Bill with a
face value of $1,000

today 90 days

Pay Price P Today Receive $1,000

Suppose you required a 2% annualized return (Discount yield). What would you
be willing to pay?

 2  90 
P  FV 1  i  i    .005
 100  360 

 DY  n  P  $1,0001  .005  $995

i  
 100  360 
 Bond Prices vs. Bond Yields

today 90 days

Pay Price P Today Receive $1,000

Note that there is a negative relationship between prices and yields

 $1,000 
P 
 1 i 
As yields go up, prices go
or
down!

P  $1,0001  i 
Interest Rates tend to rise during expansions and fall during recessions

9.00 100
90 Day T-Bill: Secondary Market
8.00
99.5
7.00
Price
6.00 99

5.00
98.5
4.00

3.00 98
Yield
2.00
97.5
1.00

0.00 97
Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

Recession Recession
A yield curve represents the average annual returns for securities of different
maturities.

i4 yr  3.50%
i3 yr  3%
i2 yr  2.5%
i1 yr  2%
Now 1 Year 2 Years 3 Years 4 years
Average annual
return on a 4 year
Average annual
bond purchased
return on a 3 year
Average annual today
bond purchased
Average annual return on a 2 year today
return on a 1 year bond purchased
bond purchased today
today

These interest rates are referred to as “spot interest rates”.

 Suppose we observe a current set of spot rates

i2 2.5%

i1 2%

Now 1 2 3 4
year years years years
Consider two investment strategies

Strategy #1: Invest $1 in a Strategy #2: Invest $1 in a 1 year bond

2 year Bond. Your 2 year and then reinvest in a one year bond in
cumulative return is one year. Your 2 year cumulative return
is
1.025 2  1.05 1.02 1  i1,1   ??
For these
1  i   1.025
2
strategies, to
pay the same 1.02 1  i1,1   1.025 2 1,1  1.03
return: 1.02
Forward rates are not observed, but can be calculated given any two spot
rates

i2 2.5%

i1 2%

Now 1 2 3 4
year years years years

i1,1 3%

1  i1,1 
 1  i2 
2

 1.025
2
 1.03
1  i1 1.02
Return on a Purchase date
1 year is 1 year from
security today i1,1  3%
 Given any yield curve, we can calculate an expected path for forward rates:

i4  3.5%
i3  3%
i2  2.5%
i1  2%

Now 1 Year 2 Years 3 Years 4 years

i1,1  3% i1, 2  4% i1,3  5%

1  i1,1 
 1  i2 
2

 1.025
2
 1.03 1  i1, 2 
 1  i3 
3

 1.03
3
 1.04  1  i4 
4
 1.035
4
1  i1,3    1.05
1  i1 1.02 1  i2  1.025 2
2
1  i3  3 1.03 3
 Alternatively, suppose we know the path of forward rates…

2% 2.5%
i1,0 i1,1

Now 1 2 3 4 years
Year Years Years

Again, consider two investment strategies

Strategy #1: Invest $1 in a 1 year bond Strategy #2: Invest $1 in a

and then reinvest in a one year bond in 2 year Bond. Your 2 year
one year. Your 2 year cumulative return cumulative return is
is
1.021.025  1.0455 1  i2  2  ??
For these
1
strategies, to
pay the same 1.021.025  1  i2  2
1  i2    1.021.025  2
return:
 Given a set of forward rates, we can calculate the implied spot rates

i1  2% i1,1  3% i1, 2  4% i1,3  5%

Now 1 Year 2 Years 3 Years 4 years

2%
1.02
2.5%
1
 1.021.03  2  1.025
3%
1
 1.021.031.04  3  1.03
3.5%
1
 1.021.031.041.05  4  1.035

Spot rates are based on the geometric average of expected future rates
What can we learn from the US yield curve?
 Suppose that expected future rates were expected to be constant

i0,1  3% i1,1  3% i1, 2  3% i1,3  3%

Now 1 Year 2 Years 3 Years 4 years

3%
1.03
3%
1 The yield curve is
 1.031.03  2  1.03 flat!

3%
1
 1.031.031.03  3  1.03
3%
1
 1.031.031.031.03  4  1.03
 An upward sloping yield curve suggests that the market expects interest
rates to rise in the future…with one small problem..

Strategy #1: Invest $1 in a Strategy #2: Invest $1 in a 1 year bond

2 year Bond. Your 2 year and then reinvest in a one year bond in
cumulative return is one year. Your 2 year cumulative return
is
1.025 2  1.05 1.02 1  i1,1   ??

For these strategies, to pay the

same return..
i1,1  3%
Are these two strategies actually equivalent??

Strategy #1 is less flexible and, hence, a bit riskier! Therefore, the

180 day rate has two components: and expected future rate AND a
liquidity premium
Finally, any security with “default risk” will offer a higher rate of return to compensate investors for
the possibility of default.

20.00

18.00
Large Spread
16.00

14.00

12.00

10.00

8.00

6.00

4.00
Small Spreads
2.00

0.00
4/1/53 4/1/61 4/1/69 4/1/77 4/1/85 4/1/93 4/1/01

10 Year Treasury Aaa Corporate Baa Corporate

 Suppose that you invest $945 in a one year, $1,000 T-Bill. Prices are listed below
as well

Now 1 Year
Pay $945 Receive $1,000

CPI = 100 CPI = 104

 $1,000  $945 
BEY    *100  5.82%
 $945 
Now, lets convert your $1,000 to current prices and redo the yield

 CPI   100 
FV  FV    $1, 000    $962
 CPI '   104 

 $962  $945 
BEY    *100  1.79% This is your inflation adjusted,
 $945  or, real return
Recall that nominal (currency) variables are meaningless without some
mention of prices. The same hold for interest rates.

Now 1 Year
Pay $945 Receive $1,000

CPI = 100 CPI = 104

Inflation Rate = 4%

Exact Method

1 i 1.0582
1 r  1.0175 
1  1.04

Approximation

r  i  1.82%  5.82%  4.00%

US Real Returns (1948-2014)
 At the time you bought the asset, you did not know what inflation
would be.

Now 1 Year
Pay $945 Receive $1,000

CPI = 100 Your Expectation: CPI = 102

Actual: CPI = 104
Expected
Ex Ante
inflation

r  i  e 3.82%  5.82%  2.00%

Actual inflation
Ex Post

r  i  1.82%  5.82%  4.00%

We can only measure ex post real interest rates!!

Every interest rate can be broken up into (at least) three
components

Interest Liquidity Risk Inflation

Rate = “Base” Rate + + +
Premium Premium Premium

We will explain this These are

rate explained
elsewhere
Households and Capital Markets
From the household’s perspective, capital markets provide an important
service. They allow households to reallocate their wealth across time.

Note that wealth is not the same as income. Suppose that you earn
$50,000 per year (income). You expect to work for 40 years. Your
wealth is defined as the present value if your lifetime income.

$50,000 $50,000 $50,000

W   .... 
1  i  1  i  2
1  i  40

Suppose that the interest rate is 4% (i = .04).

$50,000 $50,000 $50,000

W   ....   $989,638
1.04 1.04 2
1.04 40
 Saving and Consumption

C, Y
Without capital
markets,
consumption equals
$50,000 C Y
income at every
point in time

time

C, Y Savings < 0 (Borrowing)

With capital markets,

C
total lifetime
$50,000 Y consumption equals
total lifetime wealth
Savings > 0
time
Generally, it’s your income that fluctuates over time. Your goal is to
use capital markets to maintain a constant stream of consumption

Peak earning power

occurs just prior to
C, Y
retirement

C
S>0

S<0

S<0
Y

$0 time

Young Middle Age Old

(0 – 30) (30 – 60) (60 - ? )
Consider the following example. You currently are earning $80,000, but expect to
earn $20,000 next year. You can borrow and lend at 5% interest. Further,
assume that P = 1 and there is no inflation.

Today, you can either save (S>0) or borrow (S<0)

C  S  $80,000
Current saving influences future consumption

C '  $20,000  1.05 S

C' $20,000
C  $80,000   $99,047
1.05 1.05
PV of Lifetime
Wealth
Consumption
 C' $20,000
C  $80,000 
Future
Consumption All your wealth
1.05 1.05
spent next year
C'
Consumption
104,000 equals income

S>0

All your wealth

S<0 spent this year
20,000
Slope = 1.05
Current
Consumption
C
80,000 99,047
 What you choose to do depends on your preferences!
Total Utility
(Happiness)

U  U (C , C ')
Current Future
Consumption Consumption Value of current
consumption

The consumption that dollar

Save $1 today, what does it
cost you?
could’ve purchased? What’s
that lost consumption worth MU C
to you? Value of future
consumption

The dollar saved plus the

Save $1 today, what do you
gain next year?
interest? What’s that extra
consumption worth to you?
 1  r  MU C '
Real return on savings
 Recall that maximizing anything requires equating costs and benefits at the
margin

Benefits of saving Cost of saving

 1  r  MU C ' = MU C

Let’s rewrite this…

Marginal Rate of substitution measures
Marginal Rate the value of current consumption in
of Substitution terms of future consumption
MU C
 1 r    MRS Utility
MU C Current Pizzas Future Pizzas
MU C ' MRS   
MU C ' Utility Current Pizzas
Future Pizzas
 C '  20,000  1.05 30,000
Future
Consumption Real Interest
Rate
r
C'
S (Y  80,000, W  99,047)

104,000 1  r  MRS

r  .05
51,500

20,000

C S
50,000 80,000 99,047
S  30,000
Savings
Savings = 30,000
Current
Consumption
 Suppose that the interest rate increases to 8%...

Substitution effect: As
Real Interest
interest rates rise, current
Rate
consumption becomes
C' more expensive – spend r
less today! (Save More) Income Substitution
Effect effect
Income Effect: As
interest rates rise, r  .08
104,000 you earn more
interest income –
spend more today!
(Save Less) r  .05
51,500

20,000

C S
50,000 80,000 99,047
S  20,000 S  30,000 S  40,000
Savings
40,000 60,000
Current
Consumption
 We typically assume that the substitution effect is dominant…a rise in the real
interest rate increases savings.

C '  20,000  1.05 40,000

Real Interest
Rate
C' r
S (Y  80,000, W  99,047)

r  .08
104,000

62,000 r  .05

20,000

C S
40,000 80,000 99,047
S  30,000 S  40,000
Savings
Savings = 40,000
 Suppose that your current income increases to $100,000…

Future
Consumption Real Interest
Rate
S (Y  100,000, W  119,047)
r
C' S (Y  80,000, W  99,047)

104,000

r  .05
62,000
51,500

20,000

C S
50,000 60,000 100,000
S  30,000 S  40,000
Savings
Savings = 40,000

A rise in current income increases savings

 Suppose that your current income stays at $80,000, but your future
income rises to $40,000
Future
Consumption Real Interest

C '  40,000  1.05 20,000 Rate

r S (Y  80,000, W  118,095)
C'

104,000

r  .05
61,000
51,500 S (Y  80,000, W  99,047)
40,000

20,000

C S
50,000 80,000
S  20,000 S  30,000
Savings = 20,000 Savings
60,000

A rise in future income lowers savings

 Suppose that your current income rises to $100,000, AND your future
income rises to $40,000

C '  40,000  1.05 30,000

Real Interest
Rate
C'
r S (Y  100,000, W  138,095)

104,000

71,500 r  .05 S (Y  80,000, W  99,047)

51,500
40,000

C S
50,000 70,000 100,000
S  30,000
Savings = 30,000 Savings

A permanent rise in income has no effect on savings

Recall the production function discussed earlier

Y  F ( A, K , L)
Labor
Output
Capital

Productivity

Typically the production function used is Cobb-Douglas

Capital’s Share of Labor’s Share of

Income Income
1 2
Y  AK L 3 3
 The investment decision is based on changing the capital stock holding
employment fixed. Note that capital can’t be adjusted instantaneously.

Y MPK=2 F ( A, K , L)
2
The Marginal Product of
Capital (MPK) measures the
change in production
associated with a small
change in the capital stock

10
MPK=10

As capital increases
(given a fixed labor
force), capital
productivity declines!! K
K K'
1 1
 Suppose that an investment opportunity costs $100. This project will generate $25 in revenues
per year (MPK), but will depreciate at 10% per year. Assume that the interest rate is 5%

What’s the cost of capital?

Borrow $100
Capital is worth $90
Buy Capital (or use
Interest owed = $5
retained earnings)
Install Capital

Now 1 Year

Use capital to produce output

Cost:
.05($100) + .10(100) = $15 Pk  r   
Lost interest Depreciation expense
Suppose that an investment opportunity costs $100. This project will
generate $25 in revenues (MPK), but will depreciate at 10% per year. The
interest rate is 5%

We will purchase capital as long as the benefits at the margin are greater than
the cost.

(Expected) future
marginal product MPK  Pk  r    User cost of
capital
of new capital
once installed
The optimality condition for capital gives us our “target” capital stock. To
find investment, we need to remember that capital evolves according to

Target
K '  1    K  I
Capital
Stock
Current
MPK = UC Current
Capital Investment
Annual Stock
Depreciation
Rate

We need to solve for the level of investment needed to

reach our target capital stock

I  K '1    K
Example: F ( A, K , L) FK ( A, K , L)

Capital Output MPK

r  .05
1 140   .10 PK  r     15
2 180 40 PK  $100
3 210 30
K 2
4 230 20
5 245 15
6 250 5

For the production function given

above, at a user cost of 15, 5 units I  5  1  .10  2  3.2
of capital are needed
 Investment demand records the by
the firm at every real interest rate F ( A, K , L) FK ( A, K , L)

Capital Output MPK

1 140

Real
2 180 40
Interest
3 210 30
I  MPK 
Rate
r 4 230 20
5 245 15
6 250 5
r  .05 r  .05
  .10 PK  r     15
PK  $100 K 5
K 2
I
I  3.2
Investment I  5  1  .10  2  3.2
 Changing the interest rate allows us
to sketch out investment demand F ( A, K , L) FK ( A, K , L)

Capital Output MPK

1 140

Real
2 180 40
Interest
Rate
3 210 30
r 4 230 20
5 245 15
r  .10 6 250 5
r  .05 r  .10
  .10 PK  r     20
I  MPK  K 4
PK  $100
K 2
I
I  2.2 I  3.2
Investment I  4  1  .10  2  2.2
 Changing production values allows
us to sketch out shifts in investment F ( A' , K , L) FK ( A' , K , L)
demand
Capital Output MPK
1 120

Real
2 140 20
Interest
Rate
3 155 15
r 4 165 10
5 170 5
6 172 2
r  .05 r  .05
  .10 PK  r     15
I  MPK  K 3
PK  $100
I  MPK 
K 2
I
I  0.2 I  3.2
Investment I  3  1  .10  2  0.2
Anything that raises (lowers) the productivity of capital will increase (decrease)
investment demand
The productivity of capital is
influenced by
Employment (+)
r Technology (+)

I  MPK 
I
I
Finally, we need to find an equilibrium in the capital market – a real interest rate
that equates savings (inflow into financial sector) and Investment (outflow from
financial sector)

Y r
S  Y ,W 
F ( A, K , L)
*
Y
r*

I  MPK 
L S, I
L* SI
Labor Markets Given Current Income and the
determine current current capital stock, Capital markets
output (Income) determine Savings, Investment, and
the real interest rate
We need to make assumptions about the evolution of productivity (and, hence,
income) to know what happens to savings. Let’s suppose that productivity
evolves according to an autoregressive process

At 1   At   t
Productivity shock
Persistence parameter

At
At    1

At  0    1
At    0
L
Suppose that the economy experiences a temporary increase in productivity

   0 For a given level of

capital and labor, a rise
in productivity raises
output

Y r
S  Y ,W 
F ( A, K , L)
*
Y
Increase in
productivity r*

I  MPK 
L S, I
*
L SI
Suppose that the economy experiences a temporary increase in productivity

Y r
S  Y ,W 
F ( A, K , L)
*
Y
r*

I  MPK 
L S, I
L* SI

With an increase in both the supply of loanable funds (savings) and the demand
for loanable funds (investment), the interest rate change is ambiguous, and the
quantity of both savings and investment increase
 An increase in productivity that is perceived to be permanent will have minimal
effect on savings (permanently higher income raises consumption), but
investment increases    1

Y r
S  Y ,W 
F ( A, K , L)
Y*
Increase in
productivity r*

I  MPK 

L*
L S, I
SI

Interest Rates increase

Capital Markets and the business cycle

Given the mechanics of capital markets,

what relationships would we expect to see
between savings, investment, interest rates,
and output?

Just the facts ma’am. Correlation Output

Savings +

Consumption +

Investment +

Interest Rates ?
 GDP vs. Savings (% Deviation from trend)

Correlation = .77
Savings (% Dev. From trend)

GDP (% Deviation from Trend)

 GDP vs. Consumption (% Deviation from trend)

Correlation = .78
GDP/Consumption (% Dev. From trend)
 GDP vs. Investment (% Deviation from trend)

Correlation = .83

GDP (% Dev. From Trend)

Investment (% Dev. From Trend)
GDP vs. Interest Rates (% Deviation from trend)

Correlation = .42

The high, positive correlation suggests shocks that are more permanant
Example: Oil Price Shocks in the 1970’s

1979 Iranian
Revolution
(Temporary Shock)
Dollars per Barrel

1973 Arab Oil

Embargo
(Permanent Shock)
We can view the rapid rise in the price of oil as a decline in
productivity…

S  Y ,W 
r r S  Y ,W 

r*
r*

I  MPK  I  MPK 
I, S I, S
SI SI

With a temporary decline, we get a drop With a temporary decline, we get a drop
in savings and investment. The new in investment. The new equilibrium has
equilibrium interest rate is ambiguous. lower interest rates
 r S r S

I I
I I
Investment (% Dev. From Trend)

Real Interest Rate

1979 Iranian
1973 Arab Oil Revolution
Embargo