CH-7-8 Savings and Investment Process – Introduction to Finance: Markets, Investments, and Financial Management : Book Guide

This Document Contains Chapters 7 to 8 Chapter 7 Savings and Investment Process CHAPTER PREVIEW An effective financial system provides the funds needed for an economy to grow in terms of gross domestic product by channeling savings into investment. The savings-investment process in the U.S. financial system begins by first generating savings. These savings may be directly invested by savers, or be accumulated by financial intermediaries which, in turn, lend and invest the savings. After describing the composition of gross domestic product (GDP), we discuss the expenditures and receipts of the federal government. We next cover the historical role and creation of savings in the U.S. Then our attention turns to coverage of the major sources of savings and the factors that affect savings. The last two sections in the chapter cover first capital market securities and then provide a further look at the 2007-09 financial crisis. Instructors will find a vast amount of information on aggregate savings, investment, and government receipts and expenditures in newspapers, periodicals, and the reports of banks and other financial institutions. The Economic Report of the President, issued early each year, is an especially good source of statistical tables and charts as well as general information. LEARNING OBJECTIVES Identify and briefly describe the major components of the gross domestic product. Describe how the balance between exports and imports affects the gross domestic product. Describe recent developments in the aggregate level of personal and corporate savings. Describe the principal sources of federal government revenues and expenditures. Discuss the historical role of savings in the United States and how savings are created. Identify the major sources of savings in the United States. Identify and describe the factors that affect savings. Describe major capital market securities that facilitate the savings and investment process. Discuss the role of individuals in the recent financial crisis. CHAPTER OUTLINE I. GROSS DOMESTIC PRODUCT AND CAPITAL FORMATION A. GDP Components B. Implications of International Payment Imbalances C. Link between Saving and Investment II. FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES The Budget Fiscal Policy Makers Debt Financing III. HISTORICAL ROLE OF SAVINGS IN THE UNITED STATES A. Foreign Sources of Savings B. Domestic Supply of Savings C. Creation of Savings IV. MAJOR SOURCES OF SAVINGS A. Personal Savings B. Corporate Savings V. FACTORS AFFECTING SAVINGS A. Levels of Income B. Economic Expectations C. Economic Cycles D. Life Stages of the Individual Saver E. Life Stages of the Corporation VI. CAPITAL MARKET SECURITIES VII. A FURTHER LOOK AT THE 2007-09 FINANCIAL CRISIS Early Factors A Borrowing-Related Cultural Shift VIII. SUMMARY LECTURE NOTES I. GROSS DOMESTIC PRODUCT AND CAPITAL FORMATION All of a nation’s output of goods and services may be consumed, or a portion of them may be saved. Savings can be invested to construct residential and nonresidential structures, manufacture producers’ durable equipment, and increase business inventories. This process is capital formation and results in economic growth. Gross domestic product (GDP) is a nation’s output of goods and services for a specified period of time. GDP is comprised of personal consumption expenditures (PCE), government purchases of goods and services (GP), gross private domestic investment (GPDI), and net exports of goods and services (NE). In equation form, we have: GDP = PCE + GP + GPDI + NE. (Use Tables 7.1 and 7.2 and Discussion Questions 1, 2, and 3 here.) II. FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES The magnitude of the expenditures of federal government and the revenues required to support such expenditures require much examination when considering any aspect of the nation’s economy. Expenditures touch all of us—businesses as well as individuals, as do the various taxes. Although we ordinarily think only of income or corporate taxes, large sums are raised by the federal government from fees of various types: excise taxes, postal receipts, rental receipts from federal housing projects, and a host of other sources. In contrast with the early history of the nation, the federal government now enters virtually all phases of our economic lives. Figure 7.1 should stimulate class discussion. As shown in Figure 7.1 for fiscal year 2008, the principal sources of federal revenues are: personal income taxes (39%), social security and other retirement taxes (30%) borrowing to cover deficit (15%), corporate income taxes (10%), and excise, estate, and other taxes (6%). As shown in Figure 7.1 for fiscal 2008, the major expense items in the federal budget are: social security, medicare, and other retirement (37%), national defense, veterans, and foreign affairs (24%), social programs (including Medicaid) (20%), physical, human and community development (9%), net interest on debt (8%), and law enforcement and general government (2%). Beginning in 1970 and continuing until fiscal 1998, the federal government operated with an annual budget deficit. Surplus budgets were achieved during the next four years (fiscal 1998 through fiscal 2001). Beginning in 2002 budget deficits returned with the deficits becoming increasingly larger in recent years. Forecasts were for a $1.4 trillion deficit in fiscal 2009 and a $1.6 trillion deficit in fiscal 2010. (Use Figure 7.1and Discussion Questions 4, 5, and 6 here.) III. HISTORICAL ROLE AND CREATION OF SAVINGS Foreign capital played an important role in the economic development of the United States, for example, in the early transportation system. After the Civil War, the populace in the U.S. began to take over the function of providing savings for the capital formation process. Today, the World Bank supplies large amounts of capital to developing nations for purposes of increasing their productive capacity. Savings are income that is not consumed but held in the form of cash and other financial assets. Savings surplus occurs when an economic unit has current savings that exceed its direct investment in real assets. Savings deficit takes place when investment in real assets exceeds current savings. For example, a savings deficit occurs when business firms as a group are unable to meet their plant and equipment expenditure needs out of earnings retained in their businesses. In recent years individuals as a group have been a savings surplus unit. Corporations also have been generally a savings surplus unit. However, governments (both federal and state and local) have recently been savings deficit units. (Use Discussion Questions 7 and 8 here.) IV. MAJOR SOURCES OF SAVINGS PERSONAL SAVING IS THE SAVINGS OF INDIVIDUALS EQUAL TO PERSONAL INCOME LESS PERSONAL CURRENT TAXES LESS PERSONAL OUTLAYS. VOLUNTARY SAVINGS ARE FINANCIAL ASSETS SET ASIDE FOR USE IN THE FUTURE. CONTRACTUAL SAVINGS ARE DISCIPLINED BY PREVIOUS COMMITMENTS THAT THE SAVER HAS SOME INCENTIVE TO HONOR (E.G., ACCUMULATION OF RESERVES IN INSURANCE AND PENSION FUNDS). The savings rate is defined as personal savings divided by disposable personal income. In 2000, the personal savings rate in the U.S. was only 1.0 percent. The savings rate in 2005 was 1.4 percent. In contrast, the savings rate was 8.1 percent in 1970 and 9.2 percent in 1975. The savings rate for 2006 had increased to 2.4 percent and reached 4.6 percent in 2009 as indicated in Table 7.3. Savings are the financial assets retained by the corporation out of funds generated through business operations that are neither paid out in dividends nor invested in operating assets of the business. Funds generated through business operations include not only corporate earnings but also the conversion of operating assets to financial assets through depreciation allowances. Corporations have short-term saving for working capital purposes and long-term saving to meet future expenditures for equipment, major maintenance, and the like. See Table 7.4 for nonfinancial corporate savings in 2003, 2006, and 2008. (Use Tables 7.3 and 7.4, and Discussion Questions 9 through 12 here.) V. FACTORS AFFECTING SAVINGS Savings are defined as current income less tax payments and consumption expenditures. Factors that influence the total amount of savings in any given time period include: 1. Levels of income 2. Economic expectations 3. Economic cycles 4. Life stages of the individual saver 5. Life stages of the corporation Changes in business activity influence employment levels which, in turn, are closely associated with income levels. Cyclical movements in the economy affect both the level of savings and the types of savings. The instructor can generally involve the class in a lively discussion of the level of savings as they relate to the life stage of the individual saver. This discussion can often be extended to how the life stage of business firms, particularly corporations, impact on their level of savings. (Use Discussion Questions 13 through 18 here.) VI. CAPITAL MARKET SECURITIES The two types of financial markets are money markets and capital markets. Money markets are markets where debt securities of one year or less are issued or traded. Capital markets are markets where debt securities with maturities longer than one year and corporate stocks are issued or traded. Figure 7.2 lists five major capital market securities. They are: Mortgage: loan backed by real property in the form of buildings and houses. Treasury bond: long-term debt instrument issued by the U.S. federal government. Municipal bond: long-term debt instrument issued by a state or local government. Corporate bond: debt instrument issued by a corporation to raise long-term funds. Common stock: security that indicates ownership interest in a corporation. (Use Discussion Questions 19 and 20 here.) VII. A FURTHER LOOK AT THE 2007-09 FINANCIAL CRISIS The seeds of the 2007-09 financial crisis were sown in the 2001 recession. Stock prices peaked in 2000 with the bursting of the internet “bubble. Monetary and fiscal policy attempted to stimulate economic activity by creating an environment of low interest rates and high liquidity. Historically, U.S. consumers limited their use of debt. However, by the first decade of the twenty-first century, U.S. consumers wanted sooner, if not instant gratification with respect to buying large-ticket items. The use of credit cards increased dramatically and consumers borrowed heavily to purchase homes and other expensive durable goods. The U.S. government encouraged the expansion of home ownership to include individuals with relatively high credit risks. The bursting of the “housing price” bubble in mid-2006, followed by the decline in economic activity that resulted in a recession, caused many individuals not to be able to meet their mortgage payments and other debt obligations. (Use Discussion Question 21 here.) DISCUSSION QUESTIONS AND ANSWERS 1. What is capital formation? If all of a nation’s output of goods and services is not consumed, savings can be invested to construct residential and nonresidential structures, manufacture producers’ durable equipment, and increase business inventories. This process is capital formation and results in economic growth. 2. Describe the major components of gross domestic product. Gross domestic product (GDP) is comprised of: (a) personal consumption expenditures (PCE) which are expenditures by individuals for durable goods, nondurable goods, and services; (b) government purchases (GP) which are expenditures for goods and services by both the federal and the state and local governments; (c) gross private domestic investment (GPDI) which measures fixed investment in residential and nonresidential structures, producers’ durable equipment, and changes in business inventories; and (d) net exports (NE) of goods and services (i.e., exports minus imports). In equation form, we have: GDP = PCE + GP + GPDI + NE. Also see Table 7.1. 3. Identify the major components of net savings and describe their relative contributions in recent years. The two major components of net savings are net private saving and net government saving. Net private saving was in excess of $600 billion in 2003, 2006, and 2008. Personal saving and undistributed corporate profits are the major contributors to net private saving. Net government saving was negative in 2003, 2006, and 2008 with dissaving approaching $700 billion in 2008 causing net saving to be -$23 billion. Net government saving is comprised of federal and sate and local government savings. For 2008, the federal government saving was over -$600 billion and state and local saving was -$40 billion. Table 7.2 provides details on net saving. 4. Identify the various sources of revenues of the federal government. As shown in Figure 7.1 for fiscal year 2008, the principal sources of federal revenues are: personal income taxes (39%), social security and other retirement taxes (30%) borrowing to cover deficit (15%), corporate income taxes (10%), and excise, estate, and other taxes (6%). Identify the major expense categories in the federal budget. As shown in Figure 7.1 for fiscal 2008, the major expense items in the federal budget are: social security, medicare, and other retirement (37%), national defense, veterans, and foreign affairs (24%), social programs (including Medicaid) (20%), physical, human and community development (9%), net interest on debt (8%), and law enforcement and general government (2%). Describe whether the federal government has been operating with surplus or deficit budgets in recent years. Beginning in 1970 and continuing until fiscal 1998, the federal government operated with an annual budget deficit. Surplus budgets were achieved during the next four years (fiscal 1998 through fiscal 2001). Beginning in 2002 budget deficits returned with the deficits becoming increasingly larger in recent years. Forecasts were for a $1.4 trillion deficit in fiscal 2009 and a $1.6 trillion deficit in fiscal 2010. 7. Briefly describe the historical role of savings in the United States. In the earliest days of our economic development, most of the savings came from foreign sources. After the Civil War, the United States gradually developed to the point at which American families took over the function of providing savings for investment. In recent years, savings have been high enough for large-scale investment in foreign countries. 8. Compare savings surplus and savings deficit units. Indicate which economic units are generally one type or the other. Savings surplus exists when an economic unit has current savings that exceed its direct investment in real assets. In contrast, a savings deficit unit is characterized by expenditures in real assets that exceed current savings. As a result, savings surplus units make their surplus savings available to savings deficit units. As noted in Table 7.2, savings in recent years generally have come from individuals and business corporations. The federal government has been a savings deficit unit in recent years. State and local governments have been operating with deficit budgets in recent years. 9. Define personal saving. Personal saving is the savings of individuals and equals personal income less personal current taxes less personal outlays. 10. Also, differentiate between voluntary and contractual savings. Voluntary savings are financial assets set aside for future use. Contractual savings are disciplined by previous commitments and include such things as the accumulation of reserves in insurance and pension funds. 11. Describe the recent levels of savings rates in the United States. The savings rate is defined as personal savings divided by disposable personal income. In 2000, the personal savings rate in the U.S. was only 1.0 percent. The savings rate in 2005 was 1.4 percent. In contrast, the savings rate was 8.1 percent in 1970 and 9.2 percent in 1975. The savings rate for 2006 had increased to 2.4 percent and reached 4.6 percent in 2009 as indicated in Table 7.3. 12. How and why do corporations save? Savings are the financial assets retained by the corporation out of funds generated through business operations that are neither paid out in dividends nor invested in operating assets of the business. Funds generated through business operations include not only corporate earnings but also the conversion of operating assets to financial assets through depreciation allowances. Corporations have short-term saving for working capital purposes and long-term saving to meet future expenditures for equipment, major maintenance, and the like. See Table 7.4 for nonfinancial corporate savings in 2003, 2006, and 2008. 13. Describe the principal factors that influence the level of savings by individuals. The principal factors that influence the levels of savings by individuals are: (a) levels of income; (b) economic expectations; (c) economic cycles; and (d) the life stage of the individual saver. A discussion of each of these is provided in the chapter. 14. How do economic cycle movements affect the media or types of savings by businesses? Short-term or money market rates usually decrease during a period of economic downturn, remain relatively low during the early stages of economic recovery, rise rapidly with rapid economic growth, and peak when economic activity peaks. Financial intermediation takes place as long as the interest rates on time and savings deposits exceed other money market rates. Disintermediation occurs when the reverse interest rate relationship exists. The elimination of interest rate ceilings on time and savings deposits has resulted in a lessening of cyclical swings between intermediation and disintermediation. 15. What are the life cycle stages of individuals? The life cycle stages of individuals are: (a) formative/education developing, (b) career starting/family creating, (c) wealth building, and (d) retirement enjoyment. 16. How does each stage relate to the amount and type of individual savings? During the first stage there typically is no savings but rather a consumption of their parents’ savings. During the second stage, there is little savings but an earning power potential has been established. Most savings occur during the third stage, while the fourth stage often involves dissaving. 17. What are the life cycle stages of corporations and other business firms? The life cycle stages of a successful business firm are: (a) start-up stage, (b) survival stage, (c) rapid growth stage, and (d) maturity stage. 18. Explain how financial savings generated by a business are a function of its life cycle? During the and early stages and at least during the early part of the rapid growth stage of a successful business, the need to replace and add physical or real assets causes the firm to dissave; that is, the firm usually relies heavily on borrowed capital. However, as the firm becomes more mature, expansion begins to slow and this, along with a continuing large flow of cash, results in financial savings. 19. What are the two types of financial markets? The two types of financial markets are money markets and capital markets. Money markets are markets where debt securities of one year or less are issued or traded. Capital markets are markets where debt securities with maturities longer than one year and corporate stocks are issued or traded. 20. Identify and briefly describe the major securities that are originated or traded in capital securities markets. Figure 7.2 lists the following five major capital market securities: Mortgage: loan backed by real property in the form of buildings and houses. Treasury bond: long-term debt instrument issued by the U.S. federal government. Municipal bond: long-term debt instrument issued by a state or local government. Corporate bond: debt instrument issued by a corporation to raise long-term funds. Common stock: security that indicates ownership interest in a corporation. 21. What role did individuals play in the development of the 2007-09 financial crisis? Historically, U.S. consumers limited their use of debt. However, by the first decade of the twenty-first century, U.S. consumers wanted sooner, if not instant gratification with respect to buying large-ticket items. The use of credit cards increased dramatically and consumers borrowed heavily to purchase homes and other expensive durable goods. The U.S. government encouraged the expansion of home ownership to include individuals with relatively high credit risks. The bursting of the “housing price” bubble in mid-2006, followed by the decline in economic activity that resulted in a recession, caused many individuals not to be able to meet their mortgage payments and other debt obligations. EXERCISES AND ANSWERS Go to the U.S. Department of Commerce, Bureau of Economic Analysis website at http://www.bea.gov and determine: The current personal savings rate in the United States. The instructor will need to access the Department of Commerce web site to supplement the current personal savings rates indicated in the chapter. The amount of current corporate savings as reflected in the amount of undistributed profits. The instructor will need to access the web site for the Department of Commerce to supplement the corporate savings data presented in the chapter. Assume you are an elected member of Congress. A lobbying group has agreed to provide financial support for your reelection campaign next year. In return for the group’s support, you have been asked to champion their self-interests in the form of a spending bill that is being considered by Congress. What would you do? Ethical behavior is how an individual or organization treats other legally, fairly, and honestly. As an elected member of Congress you have a responsibility to all of your constituencies. Most individuals who seek election to Congress will need financial support of a variety of backers. However, it would be unethical to “blindly” support the self-interests of one group at the expense of other constituencies. It would be prudent to independently assess the merits of the spending bill being considered by Congress and its likely impact on all of your constituents so that you can make a well-informed, independent judgment. Match the following financial instruments and securities with their issuers. Instruments/Securities Issuers a. corporate stocks [#2] 1. commercial banks b. Treasury bonds [#3] 2. corporations c. municipal bonds [#4] 3. U.S. government d. negotiable certificates of deposit [#1] 4. state/local governments Match the following financial instruments and securities with their typical maturities. Instruments/Securities Maturities a. corporate stocks [#2] 1. less than one year b. Treasury bills [#4] 2. no maturity c. mortgages [#3] 3. up to about 30 years d. commercial paper [#1] 4. up to one year [Note: There are only four exercise assignments. Exercise 5 indicted in the text should have been numbered exercise 4.] PROBLEMS AND ANSWERS 1. A very small country’s gross domestic product is $12 million. a. If government expenditures amounted to $7.5 million and gross private domestic investment is $5.5 million, what would be the amount of net exports of goods and services? GDP = PCE + GE + GPDI + NE Where GDP = gross domestic product; PCE = personal consumption expenditures, GE = government expenditures, GPDI = gross private domestic investment, and NE = net exports of goods and services. The NE cannot be determined unless we know PCE. NE = $12 million - ?$PCE - $7.5 million - $5.5 million For example, if personal consumption expenditures = $0.0 million, then: NE = $12 million - $0.0 - $7.5 million - $5.5 million = -$1 million A positive amount of PCE would result in the NE being an even larger deficit number. 2. How would your answer change in Problem 1 if the gross domestic product had been $14 million? See comments for Problem 1. NE = $14 million - ?$PCE - $7.5 million - $5.5 million PCE could be $1 million before NE would turn negative. 3. Personal income amounted to $17 million last year. Personal current taxes amounted to $4 million and personal outlays for consumption expenditures, non-mortgage interest, and so forth were $12 million. a. What was the amount of disposable personal income last year? Disposable personal income (DPI) = personal income – personal current taxes DPI = $17 million - $4 million = $13 million b. What was the amount of personal saving last year? Personal savings (PS) = disposable personal income – personal outlays PS = $13 million - $12 million = $1 million c. Calculate personal saving as a percentage of disposable personal income. Savings rate = $1 million/$13 million = 7.7% Assume personal income was $28 million last year. Personal outlays were $20 million and personal current taxes were $5 million. a. What was the amount of disposable personal income last year? Disposable personal income (DPI) = personal income – personal current taxes DPI = $28 million - $5 million = $23 million b. What was the amount of personal saving last year? Personal savings (PS) = disposable personal income – personal outlays PS = $23 million - $20 million = $3 million c. Calculate personal saving as a percentage of disposable personal income. Savings rate = $3 million/$23 million = 13.0% 5. The components that comprise a nation’s gross domestic product were identified and discussed in the chapter. Assume the following accounts and amounts were reported by a nation last year. Government purchases of goods and services were $5.5 billion; personal consumption expenditures were $40.5 billion; gross private domestic investment amounted to $20 billion; capital consumption allowances were $4 billion; personal savings were estimated at $2 billion; imports of goods and services amounted to $6.5 billion; and the exports of goods and services were $5 billion. a. Determine the nation’s gross domestic product. See combined GDP solutions for (a) and (b) under (b). How would your answer change if the dollar amounts of imports and exports are reversed? Part A Part B Personal consumption expenditures (PCE) $40.5 billion $40.5 billion Gross private domestic investment (GPDI) 20.0 billion 20.0 billion Government purchases of goods & services (GP) 5.5 billion 5.5 billion Net exports (NE)[calculated as exports – imports] –1.5 billion 1.5 billion Gross domestic product (GDP) $64.5 billion $67.5 billion 6. Assume some of the data provided in Problem 1 [note: the correct reference should be to Problem 5] changes next year. Specifically, government purchases of goods and services increase by 10 percent; gross private domestic investment declines by 10 percent; and the imports of goods and services drop to $6 billion. Assume the other information as given remains the same next year. a. Determine the nation’s gross domestic product for next year. Personal consumption expenditures (PCE) $40.50 billion Gross private domestic investment (GPDI) 18.00 billion Government purchases of goods & services (GP) 6.05 billion Net exports (NE) [exports – imports] -1.00 billion Gross domestic product (GDP) $63.55 billion b. How would your answer change in (a) if personal consumption expenditures are only $35 billion next year and capital consumption allowances actually increase by 10 percent? Personal consumption expenditures (PCE) $35.00 billion Gross private domestic investment (GPDI) 18.00 billion Government purchases of goods & services (GP) 6.05 billion Net exports (NE) [exports – imports] -1.00 billion Gross domestic product (GDP) $58.05 billion 7. A nation’s gross domestic product is $600 million. Its personal consumption expenditures are $350 million and government purchases of goods and services are $100 million. Net exports of goods and services amount to $50 million. a. Determine the nation’s gross private domestic investment. See combined GPDI solutions for (a) and (b) under (b). b. If imports exceed exports by $25 million, how would your answer to (a) change? GDP = PCE + GPDI + GP + NE GPDI = GPD – PCE – GP – NE Part A Part B GPD $600 million $600 million Less PCE –350 million –350 million Less GP –100 million –100 million Less NE –50 million +25 million GPDI $100 million $175 million 8. A nation’s gross domestic product is stated in U.S. dollars at $40 million. The dollar value of one unit of the nation’s currency (FC) is $0.25. a. Determine the value of GDP in FC’s. $40 million × $.25 = 10 million FCs b. How would your answer in (a) change if the dollar value of one FC increases to $0.30? $40 million × $.30 = 12 million FCs 9. A country in Southeast Asia states its gross domestic product in terms of yen. Last year its GDP was 50 billion yen when one U.S. dollar could be exchanged into 120 yen. a. Determine the country’s GDP in terms of U.S. dollars for last year. (50 billion yen)/120 yen = $416.7 million b. Assume the GDP increases to 55 billion yen for this year. However, the dollar value of one yen is now $0.01. Determine the country’s GDP in terms of U.S. dollars for this year. (55 billion yen) × $.01 = $550 million c. Show how your answer in (b) would change if one U.S. dollar could be exchanged for 110 yen. (55 billion yen)/110 yen = $500 million 10. Challenge Problem (Note: This exercise requires knowledge of probabilities and expected values.) Following are data relating to a nation’s operations last year. Capital consumption allowances $150 million Undistributed corporate profits 40 million Personal consumption expenditures 450 million Personal savings 50 million Corporate inventory valuation adjustment -5 million Federal government deficit -30 million Government purchases of goods and services 10 million State and local governments surplus 1 million Net exports of goods and services -2 million Gross private domestic investment 200 million Determine the nation’s gross domestic product (GDP). Personal consumption expenditures (PCE) $450 million Gross private domestic investment (GPDI) 200 million Government purchases of goods & services (GP) 10 million Net exports (NE) [exports – imports] -2 million Gross domestic product (GDP) $658 million How would your answer change in (a) if exports of goods and services were $5 million and imports were 80 percent of exports? Personal consumption expenditures (PCE) $450 million Gross private domestic investment (GPDI) 200 million Government purchases of goods & services (GP) 10 million Net exports (NE) [exports – imports] -1 million Gross domestic product (GDP) $659 million Show how the GDP in (a) would change under the following three scenarios: Scenario 1 (probability of .20) that the GDP components would be 120 percent of their values in (a); Scenario 2 (probability of .50) that the GDP component values used in (a) would occur; and Scenario 3 (probability of .30) that the GDP components would be 75 percent of their values in (a). [note: this exercise requires a knowledge of probabilities and expected values.] PCE: (1) $450 million x 1.20 = $540 million; (2) $450 million x 1.00 = $450 million; and (3) $450 million x .75 = $337.50 million GPDI: (1) $200 million x 1.20 = $240 million; (2) $200 million x 1.00 = $200 million; and (3) $200 .75 = $150 million GP: (1) $10 million x 1.20 = $12 million; (2) $10 million x 1.00 = $10 million; and (3) $10 million x .75 = $7.5 million NE: (1) $-2 million x 1.20 = $-2.4 million; (2) $-2 million x 1.00 = $-2 million; and (3) $-2 million x .75 = $-1.5 million PCE Expected value (in $ millions): $540(.20) + $450(.50) + $337.50(.30) = $108 + $225 + 101.25 = $434.25 million GPDI Expected value (in $ millions): $240(.20) + $200(.50) + $150(.30) = $48 + $100 + 45 = $193 GP Expected value (in $ millions): $12(.20) + $10(.50) + $7.5(.30) = $2.4 + $5 + $2.25 = $9.65 NE Expected value (in $ millions): $-2.4(.20) + $-2(.50) + $-1.5(.30) = $-.48 + $-1 + $-.45 = $-1.93 GDP Expected value (in $ millions): $434.25 + $193 +$9.65 + ($-1.93) = $634.97 Check: $658(1.20)(.20) + $658(1.00)(.50) + $658(.75)(.30) = $157.92 + $329.00 + $148.05 = $634.97 Determine the nation’s gross savings last year. Personal savings $50 million Undistributed corporate profits 40 million Corporate inventory valuation adjustment -5 million Capital consumption allowances 150 million Federal government deficit -30 million State and local government surplus 1 million Gross savings $206 million Show how your answer in (d) would change if each account simultaneously increases by 10 percent. Gross savings: $206 million x 1.10 = $226.6 million Show how your answer in (d) would change if each account simultaneously decreases by 10 percent. Gross savings: $206 million x .90 = $185.40 Show how your answer in (d) would have changed if Capital consumption allowances had been 10 percent less and personal consumption expenditures had been $400 million. Capital consumption allowances: $150 million x .90 = $135 million Personal savings $50 million Undistributed corporate profits 40 million Corporate inventory valuation adjustment -5 million Capital consumption allowances 135 million Federal government deficit -30 million State and local government surplus 1 million Gross savings $191 million SUGGESTED QUIZ Define or discuss briefly: a. Capital formation b. Contractual savings c. Savings surplus units d. Capital market securities Identify and describe briefly the major components of gross domestic product. Comment on the general relationship between federal government receipts and expenditures in recent years. Identify and discuss briefly the major factors that affect savings. 5. List the major capital market securities described in the chapter. Chapter 8 Interest Rates CHAPTER PREVIEW Lenders charge an “interest rate” on money they “loan” to individuals and businesses. Borrowers pay an “interest rate” on money “lent” to them for a specified time period. Interest rates are determined by the supply and demand for loanable funds that exist at a point in time. We describe the determinants of nominal or market interest rates which include an inflation premium, a default risk premium, and a maturity risk premium. We follow with a description of the characteristics of U.S. Treasury debt obligations which are considered by most individuals to be free of default risk. Our attention then turns to coverage of the term or maturity structure of interest rates and why interest rates generally increase as maturities or lives of debt instruments lengthen. This will be followed by a discussion of past inflation premiums and price movements. Our last topic in the chapter addresses default risk premiums or the “quality” of bonds issued by the government and by corporations. To develop student interest, you may have students prepare a table showing changes in the term structure of interest rates and default risk premiums over the last several years. Such data can be found on the Federal Reserve Bank of St. Louis website at http://www.stlouisfed.org. Discussion time can profitably be devoted to possible reasons for any changes in each of the series and their interrelationships. Students also may be assigned a report in which they use the consumer price index to update Figure 8.3. Class discussion can be generated by asking students to write reports that examine past periods of high inflation. LEARNING OBJECTIVES Describe how interest rates change in response to shifts in the supply and demand for loanable funds. Identify major historical movements in interest rates in the United Sates. Describe the loanable funds theory of interest rates. Identify the major determinants of market interest rates. Describe the types of marketable securities issued by the U.S. Treasury. Describe the ownership of Treasury securities and the maturity distribution of the federal debt. Explain the term or maturity structure of interest rates. Identify and briefly describe the three theories used to explain the term structure of interest rates. Identify broad historical price level changes in the United States and other economies and discuss their causes. Describe the various types of inflation and their causes. Discuss the effect of default risk premiums on the level of long-term interest rates. CHAPTER OUTLINE I. SUPPLY AND DEMAND FOR LOANABLE FUNDS A. Historical Changes in U.S. Interest Rate Levels B. Loanable Funds Theory 1. Sources of Loanable Funds 2. Factors Affecting the Supply of Loanable Funds a. Volume of Savings b. Expansion of Deposits by Depository Institutions c. Liquidity Attitudes 3. Effect of Interest Rates on the Demand for Loanable Funds 4. Roles of the Banking System and of the Government 5. International Factors Affecting Interest Rates II. DETERMINANTS OF MARKET INTEREST RATES III. RISK-FREE SECURITIES: U.S. TREASURY DEBT OBLIGATIONS A. Marketable Obligations 1. Treasury Bills 2. Treasury Notes 3. Treasury Bonds B. Dealer System C. Tax Status of Federal Obligations D. Ownership of Public Debt Securities E. Maturity Distribution of Marketable Debt Securities IV. TERM OR MATURITY STRUCTURE OF INTEREST RATES A. Relationship between Yield Curves and the Economy B. Term Structure Theories V. INFLATION PREMIUMS AND PRICE MOVEMENTS A. Historical Price Movements 1. Ancient Rome 2. The Middle Ages Through Modern Times B. Inflation in the United States 1. Revolutionary War 2. War of 1812 3. Civil War 4. World War I 5. World War II and the Postwar Period 6. Recent Decades C. Types of Inflation 1. Price Changes Initiated by a Change in Costs 2. Price Changes Initiated by a Change in the Money Supply 3. Speculation and Administrative Inflation VI. DEFAULT RISK PREMIUMS VII. SUMMARY LECTURE NOTES I. SUPPLY AND DEMAND FOR LOANABLE FUNDS The supply and demand for loanable funds will take place as long as both lenders and borrowers have the expectation of satisfactory returns. Figure 4.1 can be used to graphically show how interest rates are determined in the financial markets. Supply and demand for loanable funds as of a particular point in time establish an equilibrium interest rate level. Interest rates may move from an equilibrium level if an unanticipated change or shock (e.g., higher rate of inflation) occurs that will cause the demand for, or supply of, loanable funds to change. The loanable funds theory (referred to as a flow theory) holds that interest rates are a function of the supply of and demand for loanable funds. Factors affecting the supply of loanable funds include: volume of savings, expansion of credit by depository institutions, and liquidity attitudes. Since the Civil War, there have been four periods of rising or relatively high long-term interest rates and three periods of low or falling interest rates on long-term loans and investments. (Use Figure 8.1 and Discussion Questions 1 through 6 here.) II. DETERMINANTS OF MARKET INTEREST RATES In addition to supply and demand relationships, interest rates (r) are determined by: the real rate of interest (RR); an inflation premium (IP); a default risk premium (DRP); a maturity risk premium (MRP); and a liquidity premium (LP). In equation form, we have: r = RR + IP + DRP + MRP + LP. The real rate of interest is the interest rate on a risk-free financial debt instrument. The inflation premium is the average inflation rate expected over the life of the debt instrument. The default risk premium indicates compensation for the possibility that the borrower will not pay interest and/or repay principal according to the financial instrument’s contractual arrangements. The maturity risk premium is the added return expected by lenders or investors because of interest rate risk (possibility of fluctuations in market values due to market interest rate changes) on instruments with longer maturities. The liquidity premium is compensation for those financial debt instruments that cannot be easily converted to cash at prices close to their estimated fair market values. (Use Discussion Question 7 here.) III. RISK-FREE SECURITIES: U.S. TREASURY DEBT OBLIGATIONS The obligations of the federal government are so vast that they now dominate both short-term and long-term capital markets. They play an important role in the investment patterns of most financial institutions. While interest received from federal obligations is subject to federal taxes, it is not taxable by state and municipal authorities. Because federal obligations are the highest quality available, all other obligations must provide yields scaled above those of the government. Only the yields on municipal obligations are lower due to their interest exemption from federal taxes rather than their quality. Students may look up these yield spreads in The Wall Street Journal, in other financial publications, or by accessing various Federal Reserve Bank Web sites. The obligations of the federal government are broadly classed as marketable and nonmarketable. Marketable obligations such as Treasury bills (having the shortest maturities), Treasury notes, and Treasury bonds constitute the bulk of total obligations. Nonmarketable obligations are represented primarily by U.S. savings bonds. A recent issue of the Treasury Bulletin may be used to determine the relative magnitude of the various types of obligations. This information also may be obtained from the Treasury’s Web site. Outstanding issues of federal obligations are traded actively in the nation’s secondary bond markets. A select group of dealers, made up of both large commercial banks and nonbank institutions, dominate this secondary market. The dealers buy and sell securities for their own account, arrange transactions with both their customers and other dealers, and also purchase debt directly from the Treasury for resale to investors. (Use Discussion Questions 8 through 11 here.) The very magnitude of the federal debt means that obligations representing that debt play a role in most investment portfolios. Ownership by individual groups is shown in Table 8.1. Of special interest is the importance of government agencies and trust funds. Foreign and international investors currently own about 21% of federal debt securities. While continued accumulation by government agencies can be assumed, continued foreign and international investment in federal obligations depends on their appeal. The U.S. Treasury has become dependent on foreign purchases of its obligations. These foreign investors have a special interest in the efforts of this nation to achieve a balanced budget. (Use Table 8.1 and Discussion Question 12 here.) Table 8.2 provides a picture of the maturity distribution of the federal debt. Short-term obligations (within a 1 year maturity) account for over one-third of the outstanding marketable interest-bearing federal obligations. This category, coupled with the 1–5 years category, account for about two-thirds of the outstanding federal debt. From the end of World War II, the average maturity of the debt declined dramatically until it reached a low of 2 years and 5 months in 1975. The average maturity then increased and was an even 6 years in 1989. By 2000, the average maturity declined slightly down to 5 years and 10 months. The average maturity at the end of 2003 was 5 years and 1 month, 4 years and 9 months by the end of 2006, and had dropped to 3 years and 10 months by November, 2008. Refunding is now much more flexible and can be carried out at the times and in a manner that the financial markets are least disturbed. (Use Table 8.2 and Discussion Questions 13 and 14 here.) IV. TERM OR MATURITY STRUCTURE OF INTEREST RATES The term structure of interest rates refers to the impact of debt maturities on interest rates. The term structure is shown graphically in terms of yield curves, which are constructed by graphing yields on debt securities with comparable default risk against their maturities as of a specific point in time. Three theories are used to explain the term structure of interest rates: expectations theory, liquidity premium theory, and market segmentation theory. The expectations theory reflects investor expectations about future short-term and long-term inflation rates. If inflation rates are expected to be the same across all maturities, then the yield over time on short-term securities is expected to be the same as the current rate on long-term securities. Under the liquidity premium theory, investors are willing to trade off some yield for the greater liquidity that is inherent in short-term securities. Thus, the yield curve is expected to be upward sloping. The market segmentation theory contends that securities with different maturities are less than perfect substitutes for each other. Thus, the yield curve is influenced by institutional pressures. (Use Figure 8.2, Table 8.3, and Discussion Questions 15 and 16 here.) V. INFLATION PREMIUMS AND PRICE MOVEMENTS Wide swings in prices are not a recent phenomenon. Earliest records refer to them, giving testimony to the importance attached to the subject throughout the ages. The ancient Roman Period is often cited because of the availability of historical records of the events that led to wide price swings. The large quantities of gold and other precious metals brought to Rome as a result of conquests in Egypt gave rise to increasing prices and interest rates. The use of precious metals as money meant an increase in the money supply relative to the supply of goods and services—hence, there was inflation. Nero’s debasements of gold and silver coins were numerous and, as history reveals, irreversible. During the Middle Ages, debasement of coinage was frequently used as a source of revenue for princes and kings, particularly in France. Records indicate that debasement often provided greater revenues for French rulers than any other source. Spain brought back huge supplies of gold and silver from Mexico and Peru and, as in Rome, prices increased as the circulating money supply (precious metals) increased. With its huge stores of precious metals, Spain was able to purchase goods from other countries that had not been equally affected by price increases. This led to a decline in Spain’s domestic productivity. Once its precious metals were spent, Spain was left with an economy ill prepared to compete against other countries that had benefited from productivity increases. Inflation was somewhat restrained during World War I, but shortly thereafter (in 1923) Germany experienced one of the wildest periods of inflation in history. Inflation was again somewhat restrained during World War II except in certain countries—for example, China and Hungary, where runaway inflation occurred. (Use Discussion Questions 17 and 18 here.) Although peacetime swings in price levels are common, the principal movements are those during or after wars. The Revolutionary War, which brought this nation into existence, was financed by inflation. Without authority to levy taxes, the Second Continental Congress issued notes in ever increasing amounts until they were virtually worthless. The phrase “not worth a continental” became a part of the American language. The War of 1812 was financed by issuing bonds of small denomination bearing no interest and having no maturity date. Prices went up and a depression followed. The Civil War was financed, in part, through the issuance of paper money called “greenbacks.” Inflation resulted and post-war attempts to retire the greenbacks resulted in depression. Greenbacks continue to circulate to this day, but they are mainly collectors’ items. About two-thirds of the total cost of World War I was financed by heavy borrowing, much of it from the banking system. Prices rose and then dropped following the war. During World War II, attempts were made to avoid inflationary finance through price control mechanisms. Nevertheless, huge sums were borrowed from the banking system and from the sale of savings bonds to individuals. When the controls were lifted after the war, inflation resulted. Prices rose during the Korean War; they rose again during the 1955–1957 period of expansion in economic activity following the 1954 recession. During the buildup of the Vietnam War, prices increased somewhat, but following that conflict they rose at the highest rate since World War I. While inflation in the U.S. during the mid-1970s was intense as a result of the oil crisis in the Middle East, inflationary pressures were even greater in many other industrial countries. As the 1970s ended, the general public became cynical about prospects for controlling inflation—they simply built inflation into their expectations. One result was extremely high nominal interest rates as investors attempted to protect fixed income investments from declining purchasing power. Monetary restraint was exercised in 1980, which quickly led to a depressing effect on the economy. This restraint was then abandoned and monetary stimulus drove interest rates to new peaks. The Reagan administration reversed the monetary stimulus and a decline in the economy quickly followed. By the end of 1982, economic recovery was back in place and the back of inflation had been broken. Throughout the first decade of the twenty first century, inflation remained at historically low levels. For example, see Figure 8.3. (Use Figure 8.3 and Discussion Questions 19 and 20 here.) The price level can, at times, increase without changes in the money supply or velocity, if costs increase faster than productivity. These costs will eventually be passed on to consumers in the form of higher prices. This type of inflation is referred to as cost-push inflation. This distinguishes it from inflation due to an increase in the money supply, which is called demand-pull inflation. In practice, both aspects of inflation are likely to be operative at the same time. Inflation may also be initiated by especially large changes in demand in certain industries. Inflation caused by increased money supply can lead to additional price pressure, referred to as speculative inflation. When prices have risen for some time, it is generally accepted that they will keep on rising. This may prove self-fulfilling for a time. Instead of higher prices resulting in decreased demand, people may buy more to stock up on goods before they get even more expensive. This happened in the late 1970s. For at least three decades, inflation has generally persisted, giving rise to belief in a long-run inflationary bias in the economy. Prices and wages tend to rise during periods of rapid economic expansion. Wage contracts that have escalator clauses to keep wages in line with prices are very effective, but at times these contracts result in wage increases greater than productivity increases. Further, the wage increases are fixed and do not decline during subsequent economic contractions. In effect, there is a sort of ratchet effect—a level of costs remaining high prevents prices from declining. The U.S. government typically takes action to relieve unemployment problems long before the ultimate effect of a prolonged recession can take effect. Large corporations tend to rely on nonprice competition rather than cut prices. These and other factors provide the basis for a long-run inflationary bias. However, inflation remained at historically low levels as of the beginning of the twenty first century. (Use Discussion Questions 21 through 23 here.) VI. DEFAULT RISK PREMIUMS We focus on the capital markets when discussing long-run inflation expectations and interest rate differentials between securities. The risk-free rate (as represented by the rate on long-term Treasury securities) is comprised of a real return component and a long-run inflation expectations component. Default risk is the probability that the issuer of a security will fail to make interest or principal payments. The difference between the risk-free rate and the interest rate on a risky corporate bond is referred to as the default risk premium. Default risk premiums indicate the degree of investor pessimism or optimism about economic expectations as of a point in time. Investors require relatively higher premiums to compensate for default risk when the economy is in a recession or is expected to enter one. This is because more firms fail or suffer financial distress during periods of recession compared with periods of economic expansion. Students might be asked to update the default risk premiums information contained in Table 8.4 in order to facilitate discussion and enhance their understanding, (Use Table 8.4 and Discussion Questions 24 and 25 here.) DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by the term “interest rate,” and how is it determined? The term interest rate is the price that equates the demand for and supply of loanable funds. An equilibrium interest rate is established when the demand by borrowers for funds equals the supply of funds by lenders. 2. Describe how interest rates may adjust to an unanticipated increase in inflation. Interest rates may move from an equilibrium level if an unanticipated change or “shock” occurs that will cause the demand for, or supply of, loanable funds to change. Graph C in Figure 8.1 can be used to illustrate the impact of an unanticipated increase in inflation. Lenders (suppliers) immediately require a higher rate of interest. This is shown by an upward shift in the supply curve for a given level of demand for loanable funds. This shift causes the interest rate (r) to increase or rise. 3. Identify major periods of rising interest rates in U.S. history and describe some of the underlying reasons for these interest rate movements. The first period of rising interest rates was from 1864 to 1873 and was based on the rapid economic expansion during the period following the Civil War. The second period, from 1905 to 1920, was based on large-scale prewar expansion and after 1914 on the inflation associated with World War I. The third period, from 1927 to 1933, was due to the boom from 1927 to 1929 and the unsettled conditions in the securities markets during the early years of the depression, from 1929 to 1933. The fourth period, from 1946 to 1982, was based on the rapid expansion in the period following the end of World War II; the Vietnam War; and in the 1970s to dislocations associated with various wage and price controls, costs associated with increased ecological concerns, and rapidly rising energy costs. Rates have been in a general downward trend since early 1982. 4. How does the loanable funds theory explain the level of interest rates? The loanable funds theory holds that interest rates are a function of the supply of and demand for loanable funds. It is viewed as a “flow” theory in that it focuses on the relative supply and demand of loanable funds during a specified time period. If the supply of funds increases, holding demand constant, interest rates will tend to fall. Likewise, an increase in the demand for loans will tend to drive up interest rates. Figure 8.1 contains graphical relationships involving the impact of changes in supply and demand from an equilibrium level. 5. What are the main sources of loanable funds? Indicate and briefly discuss the factors that affect the supply of loanable funds. The two basic sources are current savings and the creation of new funds through the expansion of credit by depository institutions. The major determinant in the long run of the volume of savings, corporate as well as individual, is the level of national income. Also important is the pattern of income taxes, life cycle stages, and factors that affect indirect savings in the form of life insurance and pension plans. In addition, interest rate changes have a lag effect on savings associated with the use of consumer credit. The availability of short-term credit depends upon commercial bank and other depository institution lending policies and upon Federal Reserve policies that affect them. The availability of long-term credit of different types depends upon the policies of the many different suppliers of credit. Liquidity attitudes are also important. Liquidity attitudes are a significant factor, at times, in determining the available supply of loanable funds, both long-term and short-term, relies on the attitude of lenders regarding the future. For example, it is possible that liquidity attitudes may result in the holding of some funds idle that would normally be available for lending because of uncertainty about the outlook for the economy. 6. Indicate the sources of demand for loanable funds and discuss the factors that affect the demand for loanable funds. The demand for loanable funds comes from all sectors of the economy. Businesses borrow to finance current operations and to buy plants and equipment. Farmers borrow to meet short-term and long-term needs. Institutions such as hospitals and schools borrow primarily to finance new buildings and equipment. Individuals borrow on a long-term basis to finance the purchase of homes, and on an intermediate- and short-term basis to purchase durable goods or to tide them over through emergencies. Governmental units borrow to finance public buildings, to bridge the gap between expenditures and tax receipts, and to meet budget deficits. The effect of interest rates on the demand for various types of credit is summarized in the chapter. 7. What are the factors, in addition to supply and demand relationships, that determines market interest rates? Interest rates (r) are determined by the real rate of interest (RR), an inflation premium (IP), a default risk premium (DRP), a maturity risk premium (MRP), and a liquidity premium (LP) in addition to supply and demand relationships. The real rate of interest is the interest rate on a risk-free debt instrument. The inflation premium is the average inflation rate expected over the life of the debt instrument. The default risk premium indicates compensation for the possibility that the borrower will not pay interest and/or repay principal according to the contractual arrangements. The maturity risk premium is the added return expected by lenders or investors because of the possibility of fluctuations in debt values due to market interest rate changes (i.e., interest rate risk) on instruments with longer maturities. The liquidity premium is compensation for those financial debt instruments that cannot be easily converted to cash at “fair” market prices. 8. What are the types of marketable obligations issued by the Treasury? Marketable government securities, as the term implies, are those that may be purchased and sold through customary market channels. Treasury bills bear the shortest maturities of federal obligations. They are typically issued for 91 days but also are issued with a maturity of up to one year. Treasury bills are issued on a discount basis and mature at par. Treasury notes, referred to as intermediate-term federal obligations, are issued at specific interest rates with maturities of more than one year but not more than 10 years. Treasury bonds generally have an original maturity in excess of five years (the longest maturity is 30 years). These bonds bear interest at stated rates. 9. Explain the mechanics of issuing Treasury bills, indicating how the price of a new issue is determined. Treasury bills are issued on a discount basis and mature at par. Each week the Treasury bills to be sold are awarded to the dealers and other investors who submit the highest bids. When the sealed bids are opened, they are arrayed from highest to lowest; that is, those bidders asking the least discount (offering the highest price) are placed high in the array. The bids are then accepted in the order of their position in the array until all bills are awarded. Bidders seeking a high discount (and offering a low price) may fail to receive any bills that particular week. Investors interested in purchasing small volumes of Treasury bills ($10,000 to $500,000) may submit their orders on an “average competitive price” basis. The Treasury deducts these small orders from the total volume of bills to be sold. After the bills are allotted on the competitive basis described above, the smaller orders are then executed at a discount equal to the average of the competitive bids accepted for the large orders. 10. Describe the dealer system for marketable U.S. government obligations. A select group of about 40 to 50 commercial bank and nonbank dealers buy and sell securities for their own account and arrange transactions with both their customers and other dealers. New dealers are added to this select group only when they can demonstrate satisfactory responsibility and volume of activity. These large-volume dealers are designated by, and report their activity daily to, the Federal Reserve Bank of New York. 11. What is meant by the tax status of income from federal obligations? The interest on all federal obligations is now subject to ordinary federal income taxes and tax rates. Income from the obligations of the federal government is exempt from all taxing authority of state and local governments. Federal bonds, however, are subject to both federal and state inheritance, estate, or gift taxes. 12. Describe any significant changes in the ownership pattern of federal debt securities in recent years. The government made a special effort following World War II to increase the nonbank ownership of the federal debt, with emphasis on an increase in individual ownership. In addition to increased individual ownership, nonbank corporations, state and local governments, and foreign investors have dramatically increased their ownership of the debt. Ownership of the federal debt is shown in the Economic Report of the President and can be obtained from the Federal Reserve Bank of St. Louis at http://www.stlouisfed.org. Since these publications show ownership for several years, evolving changes in ownership are easily observed. 13. What have been the recent developments in the maturity distributions of marketable interest-bearing federal debt? After reaching a low level of two years and five months in late 1975, the maturity distribution of marketable interest-bearing debt increased to five years and ten months in 2000. The average maturity at the end of 2003 was five years and one month and down to four years and nine months at the end of 2006. As of November 2008, the average maturity was three years and ten months (see Table 8.2). 14. Describe the process of advance refunding of the federal debt. Advance refunding occurs when the Treasury offers owners of a given issue the opportunity to exchange their holdings well in advance of their regular maturity for new securities of longer maturity. This “leap-frogging” of maturities was begun in 1960. 15. What is the term structure of interest rates and how is it expressed? The term structure of interest rates refers to the impact of loan maturities on interest rates. This is often expressed with a “yield curve,” which includes securities of comparable risk and plots yields against maturities as of a particular point in time. 16. Identify and describe the three basic theories used to explain the term structure of interest rates. The three basic theories to explain term structure of interest rates are: a. Expectations theory: This theory reflects investor expectations about future short-term and long-term inflation rates. The long-term interest rates at any point in time reflect the average of the prevailing short-term interest rates plus short-term interest rates expected in the future. If inflation rates were expected to be the same across all maturities, the yield curve would be expected to be flat across different maturities. b. Liquidity premium theory: Because of future uncertainty, liquidity should warrant a premium. Thus, associated supply-and-demand pressures should cause short-term rates to be lower than long-term rates, making the yield curve upward sloping. c. Market segmentation theory: Securities of different maturities are less than perfect substitutes for each other and supply-and-demand factors in each market influence various segments of the yield curve. 17. Describe the process by which inflation took place before modern times. Inflation took place, at times, because the money supply increased when gold or silver hoards were seized during a war or foreign lands were colonized. The most frequent form of inflation was the debasement of coins. 18. Discuss the early periods of inflation based on the issue of paper money. The first outstanding example of this type of inflation was in France, where John Law was given a charter in 1719 for a bank that could issue paper money. Paper money was also issued in excessive quantities during the American Revolutionary War and the French Revolution. 19. What was the basis for inflation during World Wars I and II? Inflation during World War I was widespread because the money supply was increased to finance the war, but it was held in check to some degree by government action. The most spectacular inflation took place in Germany after the war when in 1923 prices soared to astronomical heights. The money supply was increased to some extent to finance World War II, but attempts to control inflation met with some success. Runaway inflation occurred, however, especially in China and Hungary. 20. Discuss the causes of the major periods of inflation in American history. Revolutionary War: issuance of excessive supplies of paper money and lack of confidence in the financial stability of the government War of 1812: issuance of paper currency Civil War: issuance of paper currency World Wars I and II: sale of bonds to the banking system Post-World War II period: increase in the cost of production due to increases in the amounts paid to the factors of production, which were greater than increases in productivity; also, increased bank credit Vietnam War and postwar period: rapid increase in government expenditures financed in part by deficits; devaluation of the dollar, first by 12 percent and then by 10 percent; poor crops in many parts of the world and drought in the Midwest in 1974; Arab oil embargo and increases in the price of crude oil by oil exporting countries 21. Explain the process by which price changes may be initiated by a general change in costs. If costs increase faster than productivity increases, they may be passed on to consumers. Costs of basic raw materials may also go up faster than the general price level in industries in which demand is in excess of supply. Until the economy is at a level of full utilization of resources, there will be increased prices and profits and, in turn, there will be a demand for wage increases, in sectors of the economy in which administered prices exist. The wage increases may spur unions in other industries to ask for similar increases. This is especially true if government deficits are used to stimulate economic activity in periods of recession. 22. How can a change in the money supply lead to a change in the price level? When resources are fully utilized, a change in the money supply increases money demand. Since supply cannot go up, prices rise. Prices will generally also rise during expansion before resources are fully utilized. This is true because bottlenecks appear in some sectors of the economy and because prices rise in expectation of the full use of resources. Prices also rise because there is a desire to establish a new balance between the desire to hold money and other assets; this leads to an increase in investment and in the demand for goods. The reverse is true if the money supply is reduced. 23. What is meant by the speculative type of inflation? When prices have risen for some time, the idea that they will keep on rising becomes widespread. This idea may become self-generating for a time since, instead of higher prices resulting in decreased demand, people may buy more goods in the belief that prices will go still higher. This may not happen in all sectors of the economy but, rather, be confined to certain areas, as it was to land prices in the Florida boom in the 1920s or to security prices in the 1928–1929 stock market heyday. 24. What is meant by a default risk premium? Default risk is the risk that a borrower will not pay interest and/or repay the principal on a loan or other debt instrument according to the agreed contractual terms. It can be measured as the difference in interest rates between a long-term Treasury bond and a specified long-term corporate bond. 25. How can a default risk premium change over time? Default risk premiums change with changes in investor pessimism or optimism about economic expectations. Since more firms fail or suffer financial distress during recessions, default risk premiums increase as the expectation of a recession increases. EXERCISES AND ANSWERS 1. Go to the Federal Reserve Bank of St. Louis website at http://www.stlouisfed.org, and find interest rates on U.S. Treasury securities and on corporate bonds with different bond ratings. a. Prepare a yield curve or term structure of interest rates. Note: the instructor will need to update the information provided in Table 8.3 and Figure 8.2. b. Identify existing default risk premiums between long-term Treasury bonds and corporate bonds. Note: the instructor will need to update the information in Table 8.4. 2. As an economist for a major bank you are asked to explain the present substantial increase in the price level, notwithstanding the fact that neither the money supply nor the velocity of money has increased. How can this occur? Inflation may be associated with a change in costs, a change in the money supply, speculation, and administrative pressures. Actually, inflation has been at relatively low levels in the U.S. in recent years. Inflation can be associated with an increase in the money supply or the velocity of money (which are ruled-out here). Inflation could be due to cost-push or demand-pull cost changes, speculation, or administrative pressures. Costs have not been rising very rapidly in recent years and little speculation has been taking place. Some administrative inflation may take place. Administrative inflation is the tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions. 3. As an advisor to the United States Treasury you have been asked to comment on a proposal for easing the burden of interest on the national debt. This proposal calls for the elimination of federal taxes on interest received from Treasury debt obligations. Comment on the proposal. Municipal (state and local) debt has interest rates that are lower than the interest rates on Treasury debt because the interest on municipal debt is exempt from federal taxes. The first most likely reaction to eliminating federal taxes on interest received from Treasury debt is that the Federal government would sell debt at lower interest rates which would reflect this tax change. However, tax receipts to the government would also decline causing the budget deficit to increase. This, in turn, would cause the Treasury to issue larger amounts of debt securities. The result might be no discernible impact on the size of the national debt. 4. As one of several advisors to the U.S. Secretary of the Treasury, you have been asked to submit a memo in connection with the average maturity of the obligations of the federal government. The basic premise is that the average maturity is far too short. As a result, issues of debt are coming due with great frequency and needing constant reissue. On the other hand, the economy is presently showing signs of weakness. It is considered unwise to issue long-term obligations and absorb investment funds that might otherwise be invested in employment-producing construction and other private sector support. Based on these conditions, what do you recommend as a course of action to the U.S. Secretary of the Treasury? The lengthening of the maturity structure of the national debt has been a long-standing problem for the Treasury. A limited number of options are available. Since the condition in this problem is that the economy is showing signs of weakness, it would be almost impossible to lengthen the average maturity significantly at this time. The best possible approach would be to schedule the sale of obligations with a spread of maturities—that is, some short, some intermediate, and a small amount of long-term maturities. When the economy shows renewed strength, the volume of obligations sold on a long-term basis can be increased. Further, advance refunding of outstanding issues can be utilized at such a time. 5. Assume a condition in which the economy is strong, with relatively high employment. For one reason or another, the money supply is increasing at a high rate and there is little evidence of money creation slowing down. Assuming the money supply continues to increase, describe the evolving effect on price levels. Although the parallel between the money supply growth rate and prices seems to no longer exist, it is generally acknowledged that there is some relationship. It is assumed that if the money supply increases faster than the supply of goods, prices must rise in response to the supply/demand situation. When the money supply increases, we are inclined to spend more as our cash balances exceed our desired levels. In due time, the increase in spending is reflected in increasing prices as production levels reach their limits. Assume you are employed as an investment advisor. You are working with a retired individual who depends on her income from her investments to meet her day-to-day expenditures. She would like to find a way of increasing the current income from her investments. A new junk bond issue has come to your attention. If you sell these high-yield bonds to a client, you will earn a higher than average fee. You wonder whether this would be a win-win investment for your retired client, who is seeking higher current income, and for you, who would benefit in terms of increased fees. What would you do? High yield or junk bonds are considered to be high risk with potential loss of interest and/or principal. Preservation of financial capital usually is of primary emphasis to retired individuals with income usually being secondary. It would be unethical (and possibly illegal) not to explain the risk associated with investing in junk bonds to the retired individual. While there is an opportunity for a higher return, there is also substantial risk in the form of possible loss of interest and the possibility that the bond principal may not be repaid at maturity. PROBLEMS AND ANSWERS Assume investors expect a 2.0 percent real rate of return over the next year. If inflation is expected to be 0.5 percent, what is the expected nominal interest rate for a one-year U.S. Treasury security? r = RR + IP = 2.0% + 0.5% = 2.5% A one-year U.S. Treasury security has a nominal interest rate of 2.25 percent. If the expected real rate of interest is 1.5 percent, what is the expected annual inflation rate? r = RR + IP IP = r – RR = 2.25% - 1.5% = 0.75% A ten-year U.S. Treasury bond has a 3.50 percent interest rate, while a same maturity corporate bond has a 5.25 percent interest rate. Real interest rates and inflation rate expectations would be the same for the two bonds. If a default risk premium of 1.50 percentage points is estimated for the corporate bond, determine the liquidity premium for the corporate bond. r = RR + IP + DRP + MRP + LP, Where the DRP exists for a corporate bond. RR and IP are the same for both bonds. There is no MRP because both bonds have equal 10-year maturities. Thus, LP = r corporate bond – r treasury bond – DRP = 5.25% - 3.50% - 1.50% = 0.25% A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year Treasury bond has an interest rate of 3.7 percent. If inflation is expected to average 1.5 percentage points over both the next ten years and thirty years, determine the maturity risk premium for the thirty-year bond over the ten-year bond. r = RR + IP + DRP + MRP + LP RR and IP are the same for both bonds and there is no DRP or LP. Thus, MRP = r 30-year Treasury – IP) – (r 10-year Treasury – IP) = (4.0% - 1.5%) – (3.7% - 1.5%) = 2.5% - 2.2% = 0.3% Or, MRP = r 30-year Treasury – r10-year Treasury = 4.0% - 3.7% = 0.3% A thirty-year U.S. Treasury bond has a 4.0 percent interest rate. In contrast, a ten-year Treasury bond has an interest rate of 2.5 percent. A maturity risk premium is estimated to be 0.2 percentage points for the longer maturity bond. Investors expect inflation to average 1.5 percentage points over the next ten years. Estimate the expected real rate of return on the ten-year U.S. Treasury bond. r = RR + IP + MRP RR = r – IP – MRP RR 10-year Treasury = 2.5% -1.5% - 0.0% = 1.0% If the real rate of return is expected to be the same for the thirty-year bond as for the ten-year bond, estimate the average annual inflation rate expected by investors over the life of the thirty-year bond. r = RR + IP + MRP If RR was 1.0% from Part (a) for the 10-year Treasury, then RR is 1.0% also for the 30-year bond. IP = r 30 year bond- r 10-year bond – RR - MRP = 4.0% - 2.5% - 1.0% - 0.2% = 0.3% 6. You are considering an investment in a one-year government debt security with a yield of 5 percent or a highly liquid corporate debt security with a yield of 6.5 percent. The expected inflation rate for the next year is expected to be 2.5 percent. a. What would be your real rate earned on either of the two investments? Government debt rate = real rate + inflation premium Real rate = 5% - 2.5% = 2.5% b. What would be the default risk premium on the corporate debt security? Risky debt rate = government debt rate + default risk premium Default risk premium = 6.5% - 5% = 1.5% 7. Inflation is expected to be 3 percent over the next year. You desire an annual real rate of return of 2.5 percent on your investments. a. What nominal rate of interest would have to be offered on a one-year Treasury security for you to consider making an investment? Government debt rate = real rate + inflation premium Government debt rate = 2.5% + 3% = 5.5% b. A one-year corporate debt security is being offered at 2 percentage points over the one-year Treasury security rate that meets your requirement in (a). What would be the nominal interest rate on the corporate security? Corporate debt rate = government debt rate + default risk premium Corporate debt rate = 5.5% + 2% = 7.5% 8. Find the nominal interest rate for a debt security given the following information: real rate = 2%, liquidity premium = 2%, default risk premium = 4%, maturity risk premium = 3%, and the inflation premium = 3%. Nominal Interest Rate (r) = Real Rate (RR) + Inflation Premium (IP) r = 2% + 3% = 5% 9. Find the default risk premium for a debt security given the following information: inflation premium = 3%, maturity risk premium = 2.5%, real rate = 3%, liquidity premium = 0%, and the nominal interest rate is 10%. r = RR + IP + DRP + MRP + LP DRP = r – RR – IP – MRP – LP DRP = 10% – 3% – 3% – 2.5% – 0% = 1.5% 10. Find the default risk premium for a debt security given the following information: inflation premium – 2.5 percent, maturity risk premium = 2.5 percent, real rate = 3 percent, liquidity premium = 1.5 percent, and nominal interest rate = 14 percent. r = RR + IP + DRP + MRP + LP DRP = r – RR – IP – MRP – LP DRP = 14% – 3% – 2.5% – 2.5% – 1.5% = 4.5% 11. Assume that the interest rate on a one-year Treasury bill is 6 percent and the rate on a two-year Treasury note is 7 percent. Basic Relationships: r = RR + IP IP = r – RR a. If the expected real rate of interest is 3 percent, determine the inflation premium on the Treasury bill. IP = 6% – 3% = 3% b. If the maturity risk premium is expected to be zero, determine the inflation premium on the Treasury note. IP = 7% – 3% = 4% c. What is the expected inflation premium for the second year? Expected inflation premium for Year 2 = 4% – 3% = 1% 12. A Treasury note with a maturity of four years carries a nominal rate of interest of 10 percent. In contrast, an 8-year Treasury bond has a yield of 8 percent. Basic Relationships: r = RR + IP RR = r – IP a. If inflation is expected to average 7 percent over the first four years, what is the expected real rate of interest? RR = 10% – 7% = 3% b. If the inflation rate is expected to be 5 percent for the first year, calculate the average annual rate of inflation for years two through four. 7% × 4 = 28% for 4 years 28% – 5% = 23% for Years 2, 3, and 4 23%/3 = 7.67% average annual rate for Years 2, 3, and 4 c. If the maturity risk premium is expected to be zero between the two Treasury securities, what will be the average annual inflation rate expected over years five through eight? IP = r – RR Treasury note: IP = 10% – 3% = 7% Treasury bond: IP = 8% – 3% = 5% 7% × 4 = 28% for first 4 years 5% × 8 = 40% for 8 years (40% – 28%)/4 = 12%/4 = 3% average annual rate for Years 5, 6, 7, and 8 13. The interest rate on a ten-year Treasury bond is 9.25 percent. A comparable maturity Aaa-rated corporate bond is yielding 10 percent. Another comparable maturity but lower quality corporate bond has a yield of 14 percent which includes a liquidity premium of 1.5 percent. Basic Relationships: r = RR + IP + DRP + MRP + LP Treasury bond rate (TBR) = RR + IP DRP = r – TBR – MRP – LP a. Determine the default risk premium on the Aaa-rated bond. Aaa rated bond: DRP = 10% – 9.25% – 0% – 0% = .75% b. Determine the default risk premium on the lower quality corporate bond. Lower quality bond: DRP = 14% – 9.25% – 0% – 1.5%.= 3.25% 14. A corporate bond has a nominal interest rate of 12 percent. This bond is not very liquid and consequently requires a 2 percent liquidity premium. The bond is of low quality and thus has a default risk premium of 2.5 percent. The bond has a remaining life of 25 years resulting in a maturity risk premium of 1.5 percent. Basic Relationships: Treasury bond rate (TBR) = RR + IP r = TBR + DRP + MRP + LP a. Estimate the nominal interest rate on a Treasury bond. TBR = r – DRP – MRP – LP = 12% – 2.5% – 1.5% – 2% = 6% b. What would be the inflation premium on the Treasury bond if investors required a real rate of interest of 2.5 percent? IP = TBR – RR = 6% – 2.5% = 3.5% 15. Challenge Problem Following are some selected interest rates. Maturity or Term Rate Type of Security 1 year 4.0% Corporate loan (high quality) 1 year 5.0% Corporate loan (low quality) 1 year 3.5% Treasury bill 5 years 5.0% Treasury note 5 years 6.5% Corporate bond (high quality) 5 years 8.0% Corporate bond (low quality) 10 years 10.5% Corporate bond (low quality) 10 years 8.5% Corporate bond (high quality) 10 years 7.0% Treasury bond 20 years 7.5% Treasury bond 20 years 9.5% Corporate bond (high quality) 20 years 12.0% Corporate bond (low quality) Plot a yield curve using interest rates for government default risk-free securities. The yield curve for government securities would be constructed using the following securities with interest rates on the vertical axis and time to maturity on the horizontal axis. Maturity Rate Government Security 1 year 3.5% Treasury bill 5 years 5.0% Treasury note 10 years 7.0% Treasury bond 20 years 7.5% Treasury bond Plot a yield curve using corporate debt securities with low default risk (high quality) and a separate yield curve for low quality corporate debt securities. The yield curves for corporate debt securities would be constructed using the following securities with interest rates on the vertical axis and time to maturity on the horizontal axis. High Quality 1 year 4.0% Corporate loan (high quality) 5 years 6.5% Corporate bond (high quality) 10 years 8.5% Corporate bond (high quality) 20 years 9.5% Corporate bond (high quality) Low Quality 1 year 5.0% Corporate loan (low quality) 5 years 8.0% Corporate bond (low quality) 10 years 10.5% Corporate bond (low quality) 20 years 12.0% Corporate bond (low quality) Measure the amount of default risk premiums, assuming constant inflation rate expectations and no maturity or liquidity risk premiums on any of the debt securities for both high quality and low quality corporate securities based on information from (a) and (b). Describe and discuss why differences might exist between high quality and low quality corporate debt securities. Corporate Treasury Default Risk Default Risk Quality Securities - Securities = Premiums High Quality: 1-year maturities 4.0% 3.5% 0.5% 5-year maturities 6.5% 5.0% 1.5% 10-year maturities 8.5% 7.0% 1.5% 20-year maturities 9.5% 7.5% 2.0% Low Quality: 1-year maturities 6.0% 3.5% 2.5% 5-year maturities 8.0% 5.0% 3.0% 10-year maturities 10.5% 7.0% 3.5% 20-year maturities 12.0% 7.5% 4.5% Low quality corporate debt requires the offering of higher default risk premiums (relative to high quality debt) to get investors to invest in riskier corporate debt. Identify the average expected inflation rate at each maturity level in (a) if the real rate is expected to average 2 percent per year and if there are no maturity risk premiums expected on Treasury securities. Inflation Nominal Rate - Real Rate = Premium 1 year 3.5% Treasury bill 2.0% 1.5% 5 years 5.0% Treasury note 2.0% 3.0% 10 years 7.0% Treasury bond 2.0% 5.0% 20 years 7.5% Treasury bond 2.0% 5.5% Using information from (d), calculate the average annual expected inflation rate over years 2 through 5. Also calculate the average annual expected inflation rates for years 6 through 10 and for years 11 through 20. Inflation Total Nominal Rate - Real Rate = Premium Inflation 1 year 3.5% Treasury bill 2.0% 1.5% 1.5% 5 years 5.0% Treasury note 2.0% 3.0% 15.0% 10 years 7.0% Treasury bond 2.0% 5.0% 50.0% 20 years 7.5% Treasury bond 2.0% 5.5% 110.0% Average annual expected inflation rates: 2-5 years: (15.0% -1.5%)/4 = 13.5%/4 = 3.375% 6-10 years: (50% - 15%)/5 = 35%/5 = 7.0% 11-20 years: (110% - 50%)/10 = 60%/10 = 6.0% Based on the information from (e), re-estimate the maturity risk premiums for high quality and low quality corporate debt securities. Describe what seems to be occurring over time and between differences in default risks. Note: It is assumed that default risk premiums are constant across all maturities of high quality corporate debt, as well as for all maturities of low quality corporate debt (of course the level of default risk premiums would be higher for low quality debt versus high quality debt). Nominal Risk-free Maturity Risk High Quality Rate Corporate Debt - Rate = Premium 1 year 4.0% Corporate loan 3.5% 0.5% 5 years 6.5% Corporate bond 5.0% 1.5% 10 years 8.5% Corporate bond 7.0% 1.5% 20 years 9.5% Corporate bond 7.5% 2.0% Low Quality 5 years 8.0% Corporate bond 5.0% 3.0% 10 years 10.5% Corporate bond 7.0% 3.5% 20 years 12.0% Corporate bond 7.5% 4.5% Maturity risk premiums are relatively higher, as well as increase more rapidly, for low quality corporate debt compared to high quality corporate debt. The differences are: 5-year maturities: 3.0% - 1.5% = 1.5% 10-year maturities: 3.5% - 1.5% = 2.0% 20-year maturities: 4.5% - 2.0% = 2.5% This assumes that the default risk premium spread between high and low corporate debt remains constant across maturities. Otherwise, the differences being observed in terms of maturity risk premiums may actually reflect differences in default risk premium spreads. SUGGESTED QUIZ 1. Define or discuss briefly: a. Real rate of interest b. Liquidity premium c. Treasury bills d. Treasury bonds e. Yield curve f. Demand-pull inflation g. Administrative inflation 2. Briefly explain the loanable funds theory of interest rates. 3. Identify and describe the factors, in addition to supply and demand, that determine nominal interest rates. 4. List and briefly describe the three basic theories used to describe the term structure of interest rates (or shape of the yield curve). 5. Briefly describe how default risk premiums are estimated. Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288