Question

A more realistic depiction of the two-period consumption model would have a

different

interest

rate for savers and borrowers. Think about it. The rate you pay for a student loan or a home

mortgage (when you are a borrower) is much

higher

than the rate you earn on a savings account

at a bank (when you are a saver/lender).

1

Let r

S

be the interest rate for a saver and r

B

be the

interest rate for borrower, such that r

S

< r

B

. Graphically show the budget constraint for the two-

period consumption model. Label your axes, endpoints, and slope of the budget constraint.

(Hint: The budget constraint will not be a single, straight line anymore.)

Answer 1

In any market, the price is what suppliers receive and what demanders pay. In financial markets, those who supply financial capital through saving expect to receive a rate of return, while those who demand financial capital by receiving funds expect to pay a rate of return. This rate of return can come in a variety of forms, depending on the type of investment.

The simplest example of a rate of return is the interest rate. For example, when you supply money into a savings account at a bank, you receive interest on your deposit. The interest paid to you as a percent of your deposits is the interest rate. Similarly, if you demand a loan to buy a car or a computer, you will need to pay interest on the money you borrow.

Let’s consider the market for borrowing money with credit cards. In 2014, almost 200 million Americans were cardholders. Credit cards allow you to borrow money from the card’s issuer, and pay back the borrowed amount plus interest, though most allow you a period of time in which you can repay the loan without paying interest. A typical credit card interest rate ranges from 12% to 18% per year. In 2014, Americans had about $793 billion outstanding in credit card debts. About half of U.S. families with credit cards report that they almost always pay the full balance on time, but one-quarter of U.S. families with credit cards say that they “hardly ever” pay off the card in full. In fact, in 2014, 56% of consumers carried an unpaid balance in the last 12 months. Let’s say that, on average, the annual interest rate for credit card borrowing is 15% per year. So, Americans pay tens of billions of dollars every year in interest on their credit cards—plus basic fees for the credit card or fees for late payments.

Shifts in Demand and Supply in Financial Markets

Those who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial investments. We will discuss each of these in turn.

Participants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, decisions about investment or saving are made across a period of time, sometimes a long period.

Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. So they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.

By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. So when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.

For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the Great Recession of 2008 and 2009, their demand for financial capital at any given interest rate shifted to the left.

To this point, we have been looking at saving in total. Now let us consider what affects saving in different types of financial investments. In deciding between different forms of financial investments, suppliers of financial capital will have to consider the rates of return and the risks involved. Rate of return is a positive attribute of investments, but risk is a negative. If Investment A becomes more risky, or the return diminishes, then savers will shift their funds to Investment B—and the supply curve of financial capital for Investment A will shift back to the left while the supply curve of capital for Investment B shifts to the right.

The United States as a Global Borrower

In the global economy, trillions of dollars of financial investment cross national borders every year. In the early 2000s, financial investors from foreign countries were investing several hundred billion dollars per year more in the U.S. economy than U.S. financial investors were investing abroad. The following Work It Out deals with one of the macroeconomic concerns for the U.S. economy in recent years.

An understanding of interest rates is important for understanding saving and investment. Put simply, an interest rate is the price of a loan, expressed as a percentage of the amount loaned each year. Thus, if the interest rate is 6%, and you borrow $100, you must pay back $106 at the end of the year. Moreover, when you deposit $10,000 in a certificate of deposit you are effectively making a loan to the bank or other financial institution. The interest rate is the price the bank pays you. In short, interest is either the reward you get for saving or the premium you pay for having funds now rather than later. As we shall see, the concept of interest is a crucial economics concept.

Why do People Invest?

People invest to make money. They figure that they can earn a higher return on their investment than it costs them to borrow the funds. If they are investing their own funds, then they invest because they figure they can earn more than on any alternative means of holding their savings, such as CD’s or in the stock market.

Some simple examples will make the point. Suppose you have five different one period investment opportunities. Each project requires $30,000. You can invest in any or all of the projects. However, if you borrow, you must repay $30,000, plus the interest rate, (1+r) for each project. Each project has a different projected value next period.

In sum, investment demand is a downward sloping function of the interest rate. The less it costs to borrow, the more attractive an investment opportunity becomes. Graphically, the demand for investment funds.

Demand for loans

The demand for loans has an inverse relationship with the interest rate. As the real interest rate falls more projects are profitable to undertake

Saving

We now want to discuss the consumer’s saving and consumption decision. Saving is, after all income minus taxes minus consumption. Thus

S = Y – T – C.

That is,

Saving = Income less Taxes less Consumption