Microeconomics: Interest Rates, Investments, and Capital Markets

Microeconomics
Eighth Edition
Chapter 16
Interest Rates,
Investments, and
Capital Markets
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Learning Objectives
16.1 Comparing Money Today to Money in the Future.
16.2 Choices over time.
16.3 Exhaustible Resources.
16.4 Capital Markets, Interest Rates, and Investments.
Introductory Definitions
• Stock - a quantity or value that is measured
independently of time.
• Flow - a quantity or value that is measured per unit of
time.
Interest Rates
• Interest rate - the percentage more that must be
repaid to borrow money for a fixed period of time.
Discount Rate
• Discount rate - a rate reflecting the relative value an
individual places on future consumption compared to
current consumption.
• If your discount rate is nearly zero
– you would gladly loan money in exchange for a positive
interest rate.
• If your discount rate is high
– you would be willing to borrow at a lower interest rate.
Compounding (1 of 4)
• If you place $100 in a bank account that pays 4%,
– at the end of a year, you can take out the interest
payment of $4 and leave your $100 in the bank to earn
more interest in the future.
• If you leave your $100 in the bank indefinitely and the
interest rate remains constant over time,
– you will receive a payment of $4 each year.
– In this way, you can convert your $100 stock into a flow
of $4-a-year payments forever.
• In contrast, if you leave both your $100 and your $4
interest in the bank,
– the bank must pay you interest on $104 at end of the
second year.
– The bank owes you interest of $4 on your original
deposit of $100
– and interest of $4 × 0.04 = $0.16 on your interest from
the first year, for a total of $4.16.
• Thus, at the end of Year 1, your account contains
$104.00  $100  1.04  $100  1.041

• By the end of Year 2, you have
$108.16  $104  1.04  $100  1.04 2
• At the end of Year 3, your account has
$112.49  $108.16  1.04  $100  1.04 3
• If we extend this reasoning, by the end of Year t,
you have
$100  1.04t.
Frequency of Compounding (1 of 2)
• To get the highest return on your savings account, you
need to check both the interest rate and the frequency
of compounding.
• Many banks pay interest more frequently than once a
year.
Frequency of Compounding (2 of 2)
• If a bank’s annual interest rate is i = 4%, but it pays interest
two times a year,
– The bank pays you half a year’s interest,
i
 2%, after six months.
2
‒ For every dollar in your account, the bank pays you
 i
 1    1.02 dollars after six months.
 2
• At the end of the year,

– the bank owes you
2
 i
 
2
1
 2  1.02  $1.0404,
 
which is your original $1 plus 4.04¢ in interest.
Interest and the Frequency of
Compounding
Table 16.1 Interest and the Frequency of Compounding
4% Interest Payments on 18% Interest Payments on

Frequency of a $10,000 Investment at a $10,000 Investment at the
Compounding the End of 1 Year, $ End of 1 Year, $
Once a year 400.00 1,800.00
Twice a year 404.00 1,881.00
Four times a year 406.04 1,925.19
Daily 408.08 1,971.64
Continuous 408.11 1,972.17
Using Interest Rates to Connect the
Present and Future
• Present value (PV) - the value of the money you put
in the bank today.
• Future value (FV) - the present value plus interest.
Future Value
• If you deposit PV dollars in the bank today and allow
the interest to compound for t years, how much
money will you have at the end?
• The future value, FV, is the present value times a
term that reflects the compounding of the interest
payments:
FV  PV  (1  i )t .
Future Value, FV, to Which $1 Grows by the
End of Year t at Various Interest Rates, i,
Compounded Annually, $
Table 16.2 Future Value, FV, to Which $1 Grows by the End of Year t at
Various Interest Rates, i, Compounded Annually, $
t, Years 1% 4% 5% 10% 20%

1 1.01 1.04 1.05 1.10 1.20
5 1.05 1.22 1.28 1.61 2.49
10 1.10 1.48 1.63 2.59 6.19
25 1.28 2.67 3.39 10.83 95.40
50 1.64 7.11 11.47 117.39 9,100.44
Note : FV  1  i  , where FV is the future value of $1 invested for t

t
years at an annual interest rate of i.
Application: Power of Compounding
• The Dutch purchased Manhattan in 1626 for $24
worth of beads and trinkets.
• If invested in a tax-free bond with a 7% APR, it would
be worth $6 trillion in 2014, more than the assessed
value of Manhattan.
• The U.S. purchased Alaska in 1867 for $7.2 million.
• If invested in the same type of bonds, it would be
worth only $150 billion, much less than Alaska’s
current value.
Present Value (1 of 2)
• If we want to have FV = $100 at the end of a year and
the interest rate is i = 4%, then:
PV × 1.04 = $100.
• Dividing both sides of this expression by 1.04,
$100
PV   $96.15
1.04
• $96.15 is needed in the bank today to have $100 next

year.
Present Value (2 of 2)
• A more general formula relating money t periods
in the future to money today:
FV
PV 
1  i 
t
Present Value, PV, of a Payment of $1 at
the End of Year t at Various Interest Rates,
i, Compounded Annually, $
Table 16.3 Present Value, PV, of a Payment of $1 at the End of Year t at
t, Years 1% 4% 5% 10% 20%
1 0.99 0.96 0.95 0.91 0.83
5 0.95 0.82 0.78 0.62 0.40
10 0.91 0.68 0.61 0.39 0.16
25 0.78 0.38 0.30 0.09 0.01
50 0.61 0.14 0.09 0.009 0.00011
1
Note : PV  ,
1  i 
t
where PV is the present value of $1 at the end of
year t at an annual interest rate of i.
Figure 16.1 Present Value of a Dollar
in the Future
The present value of a dollar is lower the farther in the future

it is paid.
Stream of Payments
• Sometimes we need to deal with payments per period,
which are flow measures, rather than a present value
or future value, which are stock measures.
Payments for a Finite Number of
Years (1 of 2)
• Suppose that you agree to pay $10 at the end of each
year for three years to repay a debt.
• If the interest rate is 10%, the present value of this
series of payments is:
$10 $10 $10

PV   2
 3  $24.87
1.1 1.1 1.1
Payments for a Finite Number of
Years (2 of 2)
• If you make a future payment of f per year for t years
at an interest rate of i, the present value (stock) of this
flow of payments is
 1 1 1 
PV  f    
 1  i  1  i  1  i  
1 2 t
Present Value, PV, of a Flow of $10 a Year for
t Years at Various Interest Rates, i,
Compounded Annually, $
Table 16.4 Present Value, PV, of a Flow of $10 a Year for t Years at
t, Years 5% 10% 20%
5 43 38 30
10 77 61 42
50 183 99 50*
100 198 100* 50*
∞ 200 100 50
*The actual numbers are a fraction of a cent below the rounded numbers
in the table. For example, the PV at 10% for 100 years is $99.9927.
Note: The payments are made at the end of the year.
Payments Forever
• If you put PV dollars into a bank account earning an
interest rate of i,
– you can get an interest or future payment of f = i × PV
at the end of the year.
– To get a payment of f each year forever, you’d have to
put in the bank:
f
PV 
i
Solved Problem 16.1
• Melody Toyota advertises that it will sell you a Corolla
for $14,000 or lease it to you. To lease it, you must
make a down payment of $1,650 and agree to pay
$1,800 at the end of each of the next two years. After
the last lease payment, you may buy the car for
$12,000. If you plan to keep the car until it falls apart
(at least a decade) and the interest rate is 10%, which
approach has a lower present value of costs?
Solved Problem 16.1: Answer
1. Calculate the present value of leasing. The present
value of leasing the car and then buying it is the sum
of the down payment of $1,650, the present value of
paying f = $1,800 at the end of each year for t = 2
years, and the present value of purchasing the car
for FV = $12,000 in t = 2 years.
2. Compare leasing to buying the car.
Future Value of Payments over Time
• Suppose that you want to know how much you’ll have
in your savings account, FV, at some future time if you
save f each year.
– at the end of t years, the account has:
FV  f 1  1  i   1  i     1  i  
 1 2 i 1
 
Inflation and Discounting
• Nominal prices - actual prices that are not adjusted
for inflation – rise at a constant rate over time.
• Real prices - constant prices that are independent of
inflation.
Adjusting for Inflation
• Suppose that the rate of inflation is g and the nominal
amount you pay next year is f
‒ This future debt in today’s dollars—the real amount you
owe—is
f
f  .
1 g
‒ If the rate of inflation is g = 10%, a nominal payment
next year is:
f
f   0.909f in today’s dollars
1.1
Nominal and Real Rates of Interest (1 of 3)
• Without inflation, a dollar today is worth
– 1 + i next year.
• With an inflation rate of g, a dollar today is worth
– (1 + i)(1 + g) nominal dollars tomorrow.
• If i = 5% and g = 10%, a dollar today is worth
– 1.05 × 1.1 = 1.155 nominal dollars next year.
• Banks pay a nominal interest rate, i rather than a real
one.
• If they’re going to get people whose real discount rate
is i to save, banks’ nominal interest rate must be such
that a dollar pays (1 + i)(1 + g) dollars next year.
• Because 1  i  (1  i )(1  g )  1  i  ig  g,
the nominal rate is i  i  ig  g.
• Rearranging the previous equation, we see that
i  g
i
1 g
Real Present Value
• To obtain the real present value of a payment
one year from now we use:
f f
PV  
1  i (1  g )(1  i )
Choices over Time
• Often decisions made by consumers and firms involve
comparisons over time.
• One way to make a choice involving time is to pick the
option with the highest present value.
Investing
• A firm makes an investment if the expected return
from the investment is greater than the opportunity
cost.
• The opportunity cost is the best alternative use of its
money, which is what it would earn in the next best
use of the money.
Net Present Value Approach (1 of 5)
• A firm has to decide whether to buy a truck for
$20,000.
A firm should make an investment only if the
present value of the expected return exceeds the
present value of the costs.
• If
– R = the present value of the expected returns to an
investment and
– C = the present value of the costs of the
investment,
– the firm should make the investment if
R > C.
• A firm should make an investment only if the net
present value is positive:
NPV = R − C > 0.
• The initial year is t = 0, the firm’s revenue in year t is
Rt, and its cost in year t is Ct.
– If the last year in which either revenue or cost is
nonzero is T, the net present value rule holds that the
firm should invest if
NPV  R  C
 R1 R2 RT 
 R0    ...  
1  i  1  i  1  i 
1 2 T
 
 C1 C2 CT 
 C0    ...    0.
     
1 2 T
 1  i 1  i 1  i 
• We can examine whether the present value of
the cash flow in each year
πt = R t − C t
– is positive.
R1  C1 R2  C 2 RT  CT
NPV  R0  C0     ... 
1  i  1  i  1  i 
1 2 T
1 2 T
 0    ...   0.
1  i  1  i  1  i 
1 2 T
Solved Problem 16.2
• Peter Guber and Joe Lacob bought the Golden State
Warriors basketball team for $450 million in 2010.
Forbes magazine estimates the team’s net income for
2009 was $11.9 million. If the new owners believed
that they would continue to earn this annual profit
(after adjusting for inflation), f = $11.9 million, forever,
was this investment more lucrative than putting the
$450 million in a savings account that pays a real
interest rate of i = 2%? At i = 3%?
• Determine the net present value of the team. The net
present value of buying the Warriors is positive given a
real interest rate of 2% if the present value of the
stream of income, $11.9 million/0.02 = $595 million,
minus the present value of the cost, which is the
purchase price of $450 million, is positive: NPV = $595
million − $450 million = $145 million > 0. However, if
the interest rate were 3%, then the present value of the
income stream is only $11.9 million/0.03 $397 million,
so the investment would not pay: $397 − $450 = −53
million < 0.
Internal Rate of Return Approach (1 of 3)
• Internal rate of return (irr) - the discount rate that
results in a net present value of an investment of
zero
1 2 T
NPV   0    ...  0
1  irr 1  irr 2
1  irr 
T
• The investment’s rate of return is found by
rearranging the previous equation and replacing i
with irr:
f
irr  .
PV
• If the firm is borrowing money to make the investment,
it pays for the firm to borrow to make the
investment if the internal rate of return on that
investment exceeds that of the next best
alternative:
irr > i.
Solved Problem 16.3
• Peter Guber and Joe Lacob can buy the Golden
State Warriors basketball team for $450 million, and
they expect an annual real flow of payments (profits)
of f = $11.9 million forever. Using the internal rate of
return approach, should they buy the team if the real
interest rate is 2%?
• Determine the internal rate of return to this investment
and compare it to the interest rate. Calculate that the
internal rate of return from buying the Warriors is
f $11.9million
irr    2.6%
PV $450million
• Because this internal rate of return, 2.6%, is greater

than the real interest rate, 2%, they buy the team.
Rate of Return on Bonds
• Bond - a piece of paper issued by a government or a
corporation that promises to repay the borrower with a
payment stream.
• Face value – the amount borrowed.
• Perpetuities – bonds that have no maturity date and
the face value is never returned.
Time Consistency
• Time consistent – People will discount an event that
occurs a decade from the time they’re asked by the
same amount today as they will one year from now.
• Present-biased preferences – When considering the
trade-off between two future moments, we put more
weight on the earlier moment as it gets closer.
Exhaustible Resources
• Exhaustible resources - nonrenewable natural
assets that cannot be increased, only depleted
When to Sell an Exhaustible
Resource (1 of 3)
• Suppose that you own a coal mine.
– In what year do you mine the coal, and in what year do
you sell it to maximize the present value of your coal?
– We assume that:
 you can sell the coal only this year or next, in a
competitive market,
 the interest rate is i, and
 the cost of mining each pound of coal, m, stays constant
over time.
Resource (2 of 3)
• Suppose that you know that the price of coal will
increase from p1 this year to p2 next year.
• The present value of your profit per pound of coal is

p2  m
p1 − m if you sell your coal this year and 1  i
if you sell it next year.
Resource (3 of 3)
• To maximize the present value from selling your coal:
– You sell all the coal this year if the present value of
selling this year is greater than the present value of
selling next year:
p2  m
p1  m  .
1 i
• You sell all the coal next year if

p2  m
p1  m  .
1 i
• You sell the coal in either year if
p2  m
p1  m  .
1 i
Price of a Scarce Exhaustible
Resource (1 of 3)
• The resource is sold both this year, year t, and next
year, t + 1, only if the present value of a pound sold
now is the same as the present value of a pound sold
next year:
pt 1  m
pt  m 
1 i
‒ where the price is pt in year t and is pt+1 in the following
year
Resource (2 of 3)
• Using algebra to rearrange this equation, we obtain
pt 1  pt  i  pt  m 
‒ which tell us how price changes from one year to the

next.
Resource (3 of 3)
• The gap between the price and the constant
marginal cost of mining grows over time
p  pt 1  pt  i  pt  m .
Figure 16.2 Price of an Exhaustible
Resource
Price in a Two-Period Example (1 of 4)
• To illustrate how the price is determined in each year,
we assume:
– there are many identical competitive mines,
– no more coal will be sold after the second year
because of a government ban, and
– that the marginal cost of mining is zero in each period.
• Setting m = 0 in the previous equation, we learn:
p2 = p1 + (i × p1) = p1(1 + i)
• Suppose that the demand curve for coal is
Qt = 200 − pt
in each year t.
– If the amount of coal in the ground is less than would
be demanded at a zero price, the sum of the amount
demanded in both years equals:
Q1 + Q2 = (200 − p1) + (200 − p2) = Q.
Q1  Q2   200  p1    200  p2   Q
– Substituting the expression for p2 from

Equation 16.10 into this resource constraint to
obtain
200  p1   200  p1(1  i )  Q
‒ and rearranging terms, we find the
400  Q
p1  .
2i
Price and Quantity of Coal Reflecting the
Amount of Coal and the Interest Rate
Table 16.5 Price and Quantity of Coal Reflecting the Amount of
Coal and the Interest Rate
Blank Q = 169, i = 10% Q = 169, i = 20% Q = 400, Any i

400  Q $110 $105 $0
P1 
2i
P2 = p1(1 + i) $121 $126 $0
Δp = p2 − p1 = i × p1 11 21 0
Q1 = 200 − p1 90 95 200
Q2 = 200 − p2 79 74 200
Share sold in Year 2 47% 44% 50%
Figure 16.3 First-Year Price in a Two-
Period Model
Application: Redwood Trees
Abundance
• If the good is so abundant that the initial gap is zero,
the gap does not grow and the price stays constant at
the marginal cost.
– Further, if the gap is initially very small, it has to grow
for a long time before the increase becomes
noticeable.
• A reserve - the amount of a resource that can be
profitably recovered using current technology.
Figure 16.4 Capital Market Equilibrium
Solved Problem 16.4
• Suppose the government needs to borrow money to
pay for fighting a war in a foreign land. Show that
increased borrowing by the government—an increase
in the government’s demand for money at any given
interest rate—raises the equilibrium interest rate,
which discourages or crowds out private investment.
Should You Go To College? (1 of 2)
Should You Go To College? (2 of 2)
Present Value, Present Value,

Thousands of 2009 Thousands of 2009
Discount Rate, % Dollars for High School Dollars for College
0 2,007 3,225
2 1,196 1,823
4 779 1,103
6 547 708
8 410 476
10 323 332
10.42 309 309
12 264 238
14 223 174

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Microeconomics

$104.00  $100  1.04  $100  1.041

$108.16  $104  1.04  $100  1.04 2

• At the end of Year 3, your account has

$112.49  $108.16  1.04  $100  1.04 3

• At the end of the year,

4% Interest Payments on 18% Interest Payments on

t, Years 1% 4% 5% 10% 20%

Note : FV  1  i  , where FV is the future value of $1 invested for t

years at an annual interest rate of i.

• $96.15 is needed in the bank today to have $100 next

The present value of a dollar is lower the farther in the future

$10 $10 $10

• Because this internal rate of return, 2.6%, is greater

• The present value of your profit per pound of coal is

• You sell all the coal next year if

‒ which tell us how price changes from one year to the

– Substituting the expression for p2 from

Blank Q = 169, i = 10% Q = 169, i = 20% Q = 400, Any i

Present Value, Present Value,

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