layout: true background-image: url(figs/tcb-logo.png) background-position: bottom right background-attachment: fixed; background-origin: content-box; background-size: 10% --- class: title-slide .row[ .col-7[ .title[ # Principles of Macroeconomics ] .subtitle[Personal Finance, Saving, Investment, & the Financial System] .author[ ### Dennis A.V. Dittrich ] .affiliation[ ] ] .col-5[ ] ] --- # Rule of 72 .row[ .col-7[ For periodic compounding, the exact doubling time for an interest rate of r percent per period is `$$t = \frac{ln(2)}{ln(1+r)} \approx \frac{72}{(100r)}$$` ]] .row[.col-6[ Future Value = compounded Present Value ] .col-6[ `$$FV=PV(1+r)^t$$` doubling: `$$2 = (1+r)^t$$` `$$ln(2) = ln(1+r)^t$$` `$$ln(2) = t\times ln(1+r)$$` `$$\frac{ln(2)}{ln(1+r)} = t \approx \frac{0.72}{r}$$` ]] --- class: practice-slide # 1. .col-8[ Let’s see how fees can hurt your investment strategy. Let’s assume that your mutual fund grows at an average rate of 7% per year—before subtracting the fees. Using the rule of 72: a. How many years will it take for your money to double if fees are 0.5% per year? b. How many years will it take for your money to double if fees are 1.5% per year (not uncommon in the mutual fund industry)? c. How many years to double if fees are 2.5% per year? ] ??? a. 10.7 years b. 12.7 years c. 15.5 years --- # Describing Risk .row[ .col-7[ To measure risk we need to know: * All possible outcomes * The probability of each outcome ] .col-5[ ### Probability A probability is a number between 0 and 1 that indicates the likelihood that a condition occurs at a given time. ]] --- # Lotteries (Risky assets) .row[ .col-7[ Possible outcomes: 1. Not losing any contact lens (0 Euro) 2. Losing one contact lens (-100 Euro) 3. Lose both contact lenses (-200 Euro) Their probabilities: 1. 50% Not losing any contact lens (0 Euro) 2. 30% Losing one contact lens (-100 Euro) 3. 20% Lose both contact lenses (-200 Euro) ] .col-5[ ### Expected Value The weighted average of the payoffs or values associated with all possible outcomes. The probabilities of each outcome are used as weights. The expected value measures the **central tendency**, the payoff or value that we would expect on average. ]] .row[ .col-7[ The expected value: `$$EW=0.5\times 0 -0.3\times 100 -0.2\times 200 = -70$$` ]] --- # Probability Distribution ![](img05/pdf.png) .col-7[ What measure would you use to describe the different distributions? ] --- # Describing Risk .row[.col-7[ ### Lotteries Possible events and their probabilities: * 50% Not losing any contact lens (0 Euro) * 30% Losing one contact lens (-100 Euro) * 20% Losing both contact lenses (-200 Euro) The expected value: `$$EW=0.5\times 0 -0.3\times 100 -0.2\times 200 = -70$$` ] .col-5[ ### The Variance The variance is the sum of the squared distances between the expected value and the outcome. * Variance measures the **variability** of the outcomes and thus is the risk. * Other measures of variability are e.g. * Spread * Quartiles * Mean absolute deviation * Standard Deviation ]] .row[.col-7[ The variance: `$$\sigma^2=0.5\cdot (0+70)^2+0.3\cdot (-100+70)^2+0.2\cdot (-200+70)^2$$` `$$=2450+270+3380=6100$$` ]] --- # Lotteries .col-7[ Should I buy an insurance for contact lenses? **No insurance** * 50% Not losing any contact lens (0 Euro) * 30% Losing one contact lens (-100 Euro) * 20% Losing both contact lenses (-200 Euro) Expected value = `\(-70\)`, Variance = `\(6100\)` **With insurance** (Costs 75 Euro, 75 Euro Reimbursement per lens): * 50% Not losing any contact lens (-75 Euro) * 30% Losing one contact lens (-100 Euro) * 20% Losing both contact lenses (-125 Euro) Expected value = `\(-92,5\)`, Variance = `\(256,25\)` ] --- class: practice-slide # 2. .row[.col-5[ a. If you talk to a broker selling the high-fee mutual fund, what will he or she probably tell you when you ask them, “Am I getting my money’s worth when I pay your high fees?” b. According to the Figure on the right, is your broker’s answer likely to be right most of the time? ] .col-7[ ![](img05/f2301.jpg) Percent of mutual funds outperformed by the S&P 500 ]] ??? a. Your broker will always say that it is worth it. b. Your broker is usually wrong, even if he or she believes it deep down. --- # Passive vs. Active Investing .row[ .col-7[ Mutual funds pool money from many customers and invest it in many firms, in return for afee. “Active funds” are run by managers who try to pick stocks. These funds often charge higher fees. “Passive funds” simply attempt to mimic a broad stock market index, such as the S&P 500. One study found that passive investing beat 97.6% of all mutual funds. ] .col-5[ Investor and business magnate Warren Buffett is often cited as an example of someone who systematically beats the market. Others think Buffett just got lucky. ![](img05/f2303.jpg) ]] --- class: practice-slide # 3. .col-8[ Consider the supply and demand for oranges. Orange crops can be destroyed by below-freezing temperatures. a. If a weather report states that oranges are likely to freeze in a storm later this week, what probably happens to the demand for oranges today, before the storm comes? b. According to a simple supply and demand model, what happens to the price of oranges today given your answer to part a? c. How does this illustrate the idea that stock prices today “bake in” information about future events? In other words, how is a share of Microsoft like an orange? ] ??? a. Demand rises today, well before the freeze. b. This pushes the price up today. c. Stock prices are like oranges because your demand for them today depends on what you think will happen to them in the future. And rumors or facts about the future health of an orange or Microsoft affect today’s demand. --- # Beating the Market .row[.col-7[ The __efficient markets hypothesis__ states that it is difficult to beat the stock market because stock prices reflect all publicly available information. * Unless an investor is trading on inside information, he or she will not systematically outperform the market. * Insider information quickly becomes public, and opportunities for profit evaporate. Proponents claim that stock prices exhibit predictable mathematical patterns. * One study examined 7,846 different strategies of technical analysis. * None of them systematically beat the market overtime. ] .col-5[ __Efficient markets hypothesis__: the prices of traded assets reflect all publicly available information. __Technical analysis__ is an approach that looks for patterns in stock and asset prices. ]] --- # Buying Risky Assets .row[.col-6[ Suppose there are two firms, A and B. The share price for company A and for company B is 10 Euro. There are two states of the world that are equally likely to occur. 1. In state 1, the share price of company A increases to 100 Euro and the share price of the company B to 20 Euro. 2. In state 2, the share price of the company A increases to 20 Euro and the shares of the company B to 100 Euro. The decision maker has to invest 100 Euro. If one only buys shares of Company A, one can buy 10 shares In state 1, one earns 900 Euro, and in state 2 one earns 100 Euro ] .col-1[] .col-5[ Expected profit `$$0.5\times 900 + 0.5\times 100 = 500$$` Variance: `$$\sigma^2=0.5(900-500)^2+0.5(100-500)^2\\ =160000$$` ]] --- # Diversification .row[ .col-5[ If one only buys shares of company B, one can buy 10 shares. In state 1, one earns 100 Euro, and in state 2 one earns 900 Euro ] .col-1[] .col-5[ If one buys 5 shares of company A and 5 shares of company B, in state 1 one earns 500 Euro, and in state 2 one earns 500 Euro `$$5\times 100+5\times 20 -100 = 500$$` ]] .row[.col-5[ Expected profit `$$0.5\times 900 + 0.5\times 100 = 500$$` Variance: `$$\sigma^2=0.5(900-500)^2+0.5(100-500)^2\\ =160000$$` ] .col-1[] .col-5[ Expected profit `$$0.5\times 500 + 0.5\times 500 = 500$$` Variance: `$$\sigma^2=0.5(500-500)^2+0.5(500-500)^2\\=0$$` ]] --- # Diversification .col-7[ By diversifying the portfolio, one can convert the high-risk expected profit of 500 Euro in a sure gain of 500 Euro. This works here so well because the shares of both companies were perfectly negatively correlated. Typically, you will not find a perfectly negatively correlated assets. But as long as the investments are not perfectly positively correlated, the risk can be reduced through diversification. Diversification into related values that have a high positive correlation will reduce the risk only slightly. ] --- ## How to Pick Stocks .row[.col-7[ Advice for investing: * Diversify. * Avoid high fees. * Compound returns build wealth. * No return without risk. Your best strategy trading strategy is _buy and hold_. **Risk-return tradeoff**: higher returns come at the price of higher risk. * To get higher returns, you need to bear higher risk. * The expected returns on different assets, adjusted for risk, should be equal. ] .col-5[ **Diversification** lowers the risk of your portfolio. Picking diverse stocks limits your exposure to things going wrong in any particular company. You should diversify across different countries and asset classes as well. The least risky assets _for_ _you_ are assets that are _negatively correlated_ with _your portfolio._ ![](img05/f2305.png) ]] --- class: practice-slide # 4. .col-8[ How is “stock market diversification” like putting money in a bank account? ] ??? Banks put your money into a lot of small investments, just like a strategy of stock market diversification. --- class: practice-slide # 5. .col-8[ What is so bad about bubbles? If the price of Internet stocks or housing rises and then falls, is that such a big problem? After all, some people say, most of the gains going up are “paper gains” and most of the losses going down are “paper losses.” Comment on this view. ] ??? Remember that prices are signals, so when the price of Internet stocks or housing goes up, that is a signal to entrepreneurs to invest more in these fields. If the price isn’t sending the right signal, there will be a misallocation of resources. Construction of new houses, for example, boomed as house prices rose. When house prices began to fall, much of this new construction turned out to be worth less than builders expected. As a result, it now seems that too many homes were built and resources were wasted. When Internet stocks boomed, hundreds of millions of miles of fiber-optic cable were laid under the ground and sea. The companies laying this cable hoped for big profits, but in the end most of them went bust, revealing their investments to have been wasteful. It is true that the houses and the fiber-optic cable will be used—it’s not all waste—but we probably built too much, too soon. Of course, investment is always a gamble since no one knows the future for certain, but to the extent that prices depart from the fundamentals, the losses created by bubbles are not just paper losses but real resource losses. The workers and machines that built those houses and fiber-optic cables could have been better used elsewhere. Another story of opportunity cost. --- # Costs of Stock Markets .row[ .col-7[ Stock markets (and other asset markets) can encourage **speculative bubbles**. Stock prices rise far higher, and more rapidly, than the fundamental prospects of the company. Capital is invested in areas where it is not very valuable. When the bubble crashes, lower prices mean people feel poorer and spend less. Workers must move from one sector to another, creating labor adjustment costs. ] .col-5[ ![](img05/f2306.png) ]] --- # The Financial Sector and the Economy .col-7[ * The financial sector is central to almost all macroeconomic debates * The **real sector** is the market for the production and exchange of goods and services * The **financial sector** is the market for the creation and exchange of financial assets * Financial assets include money, stocks, and bonds * Plays a central role in organizing and coordinating our economy ] --- ## Why is the Financial Sector Important to Macro? .col-7[ * For every real transaction, there is a financial transaction that mirrors it * The financial sector channels savings back into spending * For every financial asset, there is a corresponding financial liability * Financial assets are assets such as stocks or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations * Financial liabilities are obligations by the issuer of the financial asset ] --- ## The Financial Sector as a Conduit for Savings <img src="img05/3001.jpg" width="100%" /> .col-7[ Financial institutions channel savings back into the spending stream as loans **Saving** is outflows from the spending stream from government, households, and corporations * Savings deposits, bonds, stocks, life insurance **Loans** are made to government, households, and corporations * Business loans, venture capital loans, construction loans, investment loans ] --- class: practice-slide # 6. .col-8[ What determines the Supply of Savings? ] ??? 1. Smoothing consumption 2. Impatience 3. Market and psychological factors 4. Interest rates --- ## What Determines the Supply of Savings? .col-7[ * Smoothing consumption * Impatience * Market and psychological factors * Interest rates ] --- class: practice-slide # 7. .col-8[ Consider three countries: Jovenia (average age: 25), Mittelaltistan (average age: 45), and Decrepetia (average age: 75). Based on the lifecycle theory, which of these countries will probably have: * High savings rates? * High rates of borrowing? * High rates of dissaving? (That’s spending your past savings.) ] ??? Jovenia will probably have a high borrowing rate, Mittelaltistan will probably have a high savings rate, and Decrepetia will likely have a high rate of dissaving. --- ## Individuals Want to Smooth Consumption .row[ .col-6[ Save during working years to provide for retirement. * Savings rises as life expectancy rises (or retirement age drops) Manage fluctuations in income: Save during good times in order to ride out the bad times. ![](img05/f2904.jpg) ] .col-6[ Nobel laureate Franco Modigliani: _By borrowing, saving, and dissaving at different times in life, workers can smooth their consumption path, improving their overall satisfaction._ **Income & Consumption over the life course** .col-9[ ![](img05/income_consumption-small.png) ] .caption[AER, 2009, Karen E. Dynan, Wendy Edelberg, and Michael G. Palumbo] ] ] --- class: practice-slide # 8. .col-8[ If people want to smooth their consumption over time, what will they tend to do when they win the lottery: Spend most of it within a year or save most of it for later? ] ??? If people want to smooth their consumption, they will save most of their winnings so that they can increase their spending over time. The evidence is generally supportive of the theory if we recognize that some spending—such as spending on houses and cars—is equivalent to spending over time since these goods are durable. --- # Individuals Are Impatient .col-7[ Time preference: the desire to have goods and services sooner rather than later. * Anything with immediate costs and future benefits must overcome time preference. * People who discount future consumption more will save less now. ] --- # Marketing and Psychological Factors .col-7[ 401(k): Longterm Effect of Automatic Enrollment ![](img05/401kparticipation.png) .caption[NBER, 2004, Choi et. al] ] --- # The Interest Rate .row[.col-6[ Interest is the reward for savings. It's the _price_ of savings. The higher the interest rate, the greater the quantity saved. ] .col-6[ ![](img05/f2903.jpg) ]] --- class: practice-slide # 9. .col-8[ The typical savings supply curve has a positive slope. If a nation’s saving supply curve had a perfectly vertical slope, what would that mean? a. People save the same amount no matter what the interest rate is. b. People are extremely sensitive to interest rates when deciding how much to save. ] ??? The answer is a. A perfectly vertical curve would mean that people save the same amount no matter what the interest rate. --- class: practice-slide # 10. .col-8[ What is national saving? What is private saving? What is public saving? How are these variables related? ] ??? Closed Economy National Saving = Y-C-G=I (Y-T+TR - C) +(T-G-TR) = I Disposable Income: Y-T+TR Private Saving: (Y-T+TR) - C Public Saving = Budget surplus: T - G - TR S(r) = I(r) Open Economy Y-C-G = S = I+NX S-I = NX --- # National Savings and Investments .col-7[ ### Closed Economy: National Saving `\(= Y-C-G=I\)` `$$(Y-T+TR - C) +(T-G-TR) = I$$` Disposable Income: `\(Y-T+TR\)` Private Saving: `\((Y-T+TR) - C\)` Public Saving = Budget surplus: `\(T - G - TR\)` `$$S(r) = I(r)$$` ### Open Economy `$$Y-C-G = S = I+NX$$` `$$S-I = NX$$` ] --- class: practice-slide # 11. .col-8[ What determines the Demand for Borrowing? ] ??? 1. Smoothing consumption 2. Financing large investments 3. The interest rate --- ## What determines the demand for borrowing? .row[.col-6[ * Smoothing consumption * Financing large investments * Without the ability to borrow many profitable investments will not happen. * The interest rate * Determines the cost of the loan. * An investment will be profitable only if its rate of return is greater than the interest rate. ] .col-6[ ![](img05/f2905.jpg) ]] --- class: practice-slide # 12. .col-8[ If savers don’t feel safe putting their money in banks or buying bonds, what’s the best way to sum up what’s happening to demand, supply, and price in the market for loanable funds? ] ??? Supply of savings falls and the interest rate rises. --- ## The Role of Interest Rates in the Financial Sector .row[ .col-7[ The **interest rate** is the price paid for use of a financial asset The long-term interest rate is the price paid for financial assets with long maturities, * The market for long-term financial assets is called the **loanable funds market** At equilibrium, the quantity of loanable funds supplied (savings) is equal to the quantity of loanable funds demanded (investment) The short-term interest rate is the price paid for financial assets with short maturities, * Short-term financial assets are called **money** ] .col-5[ <img src="img05/3002.jpg" width="100%" /> ] ] --- class: practice-slide # 13. .col-8[ After a stock market crash, will people (need to) save more or save less? ] ??? If the stock market crashes, people save more to restore their wealth --- .row[ .col-7[ ![](img05/f2907.jpg) ] .col-5[ ## If the stock market crashes, people save more to restore their wealth ]] --- class: practice-slide # 14. .col-8[ If investors become more pessimistic during a recession, will they increase or reduce their borrowing? ] ??? If investors become more pessimistic during a recession, they reduce their borrowing. --- .row[.col-7[ ![](img05/f2908.jpg) ] .col-5[ ## If investors become more pessimistic during a recession, they reduce their borrowing. ]] --- # The Role of Intermediaries .col-7[ ### Banks, Bonds, and Stock Markets Financial Institutions reduce the costs of moving savings from savers to borrowers and investors. * Middlemen who help coordinate financial markets. * Help move savings to more highly valued uses. * Three financial intermediaries: * Banks * Bond markets * Stock markets ] --- class: practice-slide # 15. .col-8[ What is the role of Banks (as financial Intermediaries) in the economy? ] ??? Financial Institutions reduce the costs of moving savings from savers to borrowers and investors. Middlemen who help coordinate financial markets. Help move savings to more highly valued uses. Banks: Gather savings Reduce risk by evaluating ability to pay off loans. Spread risk When a borrower defaults on a loan, the bank spreads the loss among many depositors. Coordinate lenders and borrowers. Minimize information costs. Conclusion: Banks help gather savings and allocate it to the most productive uses. --- # Banks .col-7[ * Gather savings * Reduce risk by evaluating ability to pay off loans. * Spread risk * When a borrower defaults on a loan, the bank spreads the loss among many depositors. * Coordinate lenders and borrowers. * Minimize information costs. Conclusion: Banks help gather savings and allocate it to the most productive uses. Besides decreasing the number of banks, how do bank failures hinder financial intermediation? ] --- class: practice-slide # 16. .col-8[ Bank savings accounts typically pay an interest rate well below the inflation rate. As of spring 2011, for example, the best interest rates on savings accounts were around 1% per year, while the CPI inflation rate was around 2.5% per year. What does this mean about the real interest rate on bank savings? Knowing this, why would people still choose to deposit any money in bank savings accounts? ] ??? Bank accounts pay a negative real interest rate. But for people who desire high liquidity and low/zero risk—i.e. the ability to immediately convert their funds into cash without incurring a loss—bank accounts can still make sense. Holding cash means a real loss of the inflation rate—2.5% in the question, while savings accounts would reduce this real loss to the difference between the inflation rate and the bank’s interest rate—1.5% in the question. Holding cash also involves a risk of theft, fire, loss, etc. Savings accounts provide security against such hazards, and are also guaranteed by the government against losses through the FDIC, meaning they are considered a very low-risk “investment.” --- class: practice-slide # 17. .col-8[ What are (government) bonds? ] ??? A bond is a sophisticated IOU that documents who owns how much and when payment must be paid. Issuing bonds allows borrowing directly from the public. Lender: one who buys a bond Borrower: one who issues a bond Corporations and governments at all levels borrow money by issuing bonds. All bonds involve a risk. Major issues are graded by rating companies: Standard and Poor’s, Moody’s Grades range from lowest risk (AAA) bonds in current default (D) The higher the risk the greater the interest rate required to get lenders to buy the bonds. --- # The Bond Market .row[ .col-7[ A bond is a sophisticated IOU that documents who owns how much and when payment must be paid. * Issuing bonds allows borrowing directly from the public. * Lender: one who buys a bond * Borrower: one who issues a bond * Corporations and governments at all levels borrow money by issuing bonds. * All bonds involve a risk. * Major issues are graded by rating companies: Standard and Poor's, Moody's * Grades range from lowest risk (AAA) bonds in current default (D) * The higher the risk the greater the interest rate required to get lenders to buy the bonds. ] .col-5[ **Collateral**: something of value that by agreement becomes the property of the lender if the borrower defaults. * The higher the collateral the lower the risk (and therefore interest rate) Other elements of interest rate determination: * Repayment time * Amount of loan * Type of collateral * Risk of borrower default The higher the risk the higher will be the rate of return. * Home mortgage rates are lower than vacation loans because mortgage loans are backed by collateral. ]] --- class: practice-slide # 18. .row[.col-5[ Consider the Figure on the right. Would a rise in government borrowing make it harder or easier for a new business to sell new stocks in an initial public offering? In other words, are government bonds and corporate stocks substitutes for each other or complements to each other? ] .col-7[ ![](img05/f2906.jpg) ]] ??? A rise in government borrowing makes it more difficult for businesses to sell new stocks. Corporate stocks are substitutes for government bonds: Some investors (not all, but some!) are indifferent between investing in the two, and they can only save a given dollar one single time. They are substitutes. --- ## Governments issue bonds to borrow money. .row[.col-5[ Government borrowing can crowd out private spending. **Crowding-out**: the decrease in private consumption and investment that occurs when government borrows more. ] .col-7[ ![](img05/f2910.jpg) ]] --- # The Bond Market .row[ .col-7[ * Equally risky assets must have the same rate of return If not, there will likely be arbitrage * Interest rates and bond prices move in opposite directions Changing interest rates will change a bond's market value. * Bond buyers face interest rate risk along with default risk. ] .col-5[ **Rate of Return**: the implied interest rate the bond earns. **Arbitrage**: the buying and selling of equally risky assets (to exploit differences in price). ] ] --- class: practice-slide # 19. .col-8[ Declines in share prices are sometimes viewed as harbingers of future declines in real GDP. Why do you suppose that might be true? ] ??? Share price = Net present value of future earnings --- # The Stock Market .col-7[ A **stock** (or a **share**) is a certificate of ownership in a corporation. * Stocks are traded in organized markets called **stock exchanges**. * New York Stock Exchange (NYSE) is the largest. Tokyo Stock Exchange (TSE) is the second largest. * Sales of new shares: * **IPO (initial public offering)**: the first time a corporation sells stock to the public in order to raise capital * Typically used to buy new capital goods. * Stock markets encourage investment and growth. The value of a firm is the sum of the value of its assets and the value of the discounted future profits. ] --- class: practice-slide # 20. .col-8[ If financial intermediation breaks down, what category of GDP will probably fall the most: consumption, investment, government purchases, or net exports? ] ??? Investment. --- class: practice-slide # 21. .col-8[ When governments outlaw high interest rates and the ceiling is binding, what probably happens to the total amount of money borrowed? ] --- ## What Happens When Intermediation Fails? .col-7[ Controls on Interest Rates and Inflation * Usury Laws: create legal ceilings on interest rates. Result: less saving and investment. Insecure Property Rights * Some governments fail to protect property rights. Saved funds can be confiscated, frozen, and otherwise restricted. Result: people are reluctant to put their savings in domestic institutions. * Example: Argentina and Brazil Both have a history of freezing bank accounts. Argentines and Brazilians save less. Result: less investment and lower economic growth. ] --- ## What Happens When Intermediation Fails? .row[ .col-5[ Inflation * When combined with controls on interest rates, inflation destroys the incentive to save. * Nominal interest rate: the named rate; the rate on paper. * Real interest rate: the rate of return after adjusting for inflation. * Real interest rate = Nominal interest rate -- Inflation rate ] .col-7[ ![](img05/c27-09.png) ]] --- class: practice-slide # 22. .col-8[ a. In a competitive banking system, what tends to happen to banks that make low-interest rate loans to the banker’s friends: Do they tend to be more successful or less successful than other, more ruthless banks? b. Given your answer to the previous question, how do you suspect that politicized government-owned banks stay in business? ] ??? a. They are less successful: They are lending money to people who are less able to pay back the loan. b. The easiest guess is that it’s because they can rely on taxpayers to keep making up the difference: Whenever there’s a bad year for the government-owned bank, the bank can ask for more government funds. --- ## What Happens When Intermediation Fails? .row[ .col-6[ Politicized Lending and Government Owned Banks * Example: Japan 1990 to 2005: Many banks were bankrupt or propped up by the government (_Zombie banks_). They were not loaning funds for efficient uses. Other banks were pressured to lend money to well-connected political allies. Result: economic growth was zero during this period. ] .col-6[ Bank Failures and Panics * Systemic problems usually lead to large-scale economic crises. * During the Depression, between 1929-1933: 11,000 banks (almost half of U.S. banks) failed. * Ripple effects: * Businesses could not get working capital. * Many people lost their life savings, resulting in lower spending. * Huge amounts of bad loans on the books of financial institutions. * Banks could not get funds to loan. ]] --- class: practice-slide # 23. .col-8[ In each of the three cases, which bond will usually pay a higher interest rate? 1. A bond rated AAA, or a bond rated BBB? 2. A U.S. government bond, or a General Motors bond? 3. A Citibank bond that gets repaid in 30 years or a Citibank bond that gets repaid in 1 year? ] --- class: practice-slide # 24. .col-8[ a. If a zero-coupon bond with a face value of $1,000 payable in 1 year sells for $925, what is the interest rate? b. If another bond with the same face value and maturity sells for $900, what is the interest rate on this bond? c. Which bond, the one discussed in question a or question b, would you rather invest in? Are you sure? Think again! ] ??? a. 8.1% b. 11.1% c. It’s tempting to say that it would be preferable to invest in the second bond since it pays a higher interest rate. On second thought, however, we must ask, “Why is this bond paying a higher interest rate?” Perhaps the reason the second bond is paying a higher interest rate is that is more risky. After all, if the second bond were really a better buy, wouldn’t other investors have already purchased this bond and bid up the price? Finally, the decision would depend on one’s risk appetite. The issues raised in this question were taken up at greater length in Chapter 22 in Economics when we discussed the theory of efficient markets. --- ## The Many Interest Rates in the Economy .col-7[ The economy doesn't have just a single interest rate; it has many * Each financial asset will have an implicit interest rate associated with it In a multiple-asset market, the potential for the interest rate in the loanable funds market to differ from the interest rate in the market for a particular asset is large * The result can be what is sometimes called a financial asset market bubble An example of a financial asset market bubble: * In the early 2000s prices of houses increased by 10% to 15% per year * Many people bought houses for speculative purposes * In 2007, people lowered their expectations of housing price appreciation * The demand for housing decreased substantially, and the equilibrium price fell ]