How Shifts in Demand and Supply Affect Interest Rates; Investment Analysis Over Time; Net Present Value; Perpetuities

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From the course by University of California, Irvine

The Power of Microeconomics: Economic Principles in the Real World

858 ratings

University of California, Irvine

The Power of Microeconomics: Economic Principles in the Real World

858 ratings

In this course, you will learn all of the major principles of microeconomics normally taught in a quarter or semester course to college undergraduates or MBA students. Perhaps more importantly, you will also learn how to apply these principles to a wide variety of real world situations in both your personal and professional lives. In this way, the Power of Microeconomics will help you prosper in an increasingly competitive environment. Note that this course is a companion to the Power of Macroeconomics. If you take both courses, you will learn all of the major principles normally taught in a year-long introductory economics college course.

From the lesson

The Capital Market, Interest, and Profits

Capital Analysis in the Real World; Three Categories of Capital Goods; Interest Rate Defined; Rate of Return 7:37

Depreciation; Theory of Loanable Funds; Two Interest Rate Functions 5:46

How Shifts in Demand and Supply Affect Interest Rates; Investment Analysis Over Time; Net Present Value; Perpetuities6:48

NPV In the Real World; NPV Equation 4:11

Real World Applications of NPV 4:39

Interest Rates In The Real World; Factors Determining Interest Rates 3:24

Meet the Instructors

Dr. Peter Navarro
Professor
Paul Merage School of Business

Now let's add another layer of complexity to

this market for loanable funds by asking the question.

How might events in the real world cause the demand and supply curve

to shift and thereby change the interest

rate and the economy's level of investment?

Well, on the supply side, let's suppose the federal government significantly

expands the social security retirement program to more fully cover the cost

of hospitalization and retirement.

What is this likely to do to the supply

curve for lonable funds and the market rate of interest.

Well, the most likely response to this new government policy

would be for people to save less for their retirement.

That is to be less thrifty.

This would shift the supply of loanable funds

inward and the market rate of interest would rise.

Just as any Federal cut backs in Medicare or Social Security might

shift the supply curve outward, and cause the interest rate to fall.

Now what about the supply side.

Suppose the economy had been in a deep

recession, but now is moving towards full employment.

What do you think will happen to the interest rate and why?

Well, as the economy improves, more businesses are likely

to increase their investment in new plant and equipment.

This will, of course, shift out the

demand curve and thereby increase the interest rate.

Now, in the example above, we made it

really easy to evaluate the firm's investment decision.

We made it easy by limiting the investment horizon to only one year.

That is, we invested in something at the beginning of the

year and got our return at the end of the year.

But, that's a pretty artificial example, because most investments last

more than one year after our initial outlay of funds.

From a few years for a new computer or some office furniture, to 30 to

40 years for an electric power plant, and more than 50 years for a big skyscraper.

Our question now is, how do you evaluate

an investment when your capital outlay occurs today.

But the benefits from that investment come in

the form of a revenue stream over many years?

In order to answer this

question, we have to introduce one of the

most important concepts in economics, net present value.

Them before I explain this concept, let me point out that net present value

goes by various other names, including present

discounted value or just plain present value.

But regardless of which name is used, the concept behind

net present value is that it provides us with the time

value of money.

It is defined as the dollar value today of a stream income over time.

It is measured by calculating how much money invested today would be needed,

at the going interest rate, to generate the assets of future stream of receipts.

Let's give this definition some real world context,

so we can really wrap our minds around it.

Suppose you own an apartment building which generates

rental payments of $10,000 per month from your tenants.

Let's suppose further, that your tenants are always

calling you up in the middle of the

night to complain about a leaky faucet or

a blocked toilet or a broken waste disposal.

Enough already, you say.

So you decide to sell the building. But how much should you sell it for?

More specifically, what lump sum payment

of money today would make you at least as well off, as that

stream of rental payments that you would get over the life of the building?

To start us towards an answer to this

question, let's start with a very simple example.

One again, for only a one year investment.

Let's suppose then, that somebody offers to sell you

a bottle of wine that matures in exactly one year.

And that the wine can be sold for $11 at the end of the year.

Assuming that the market interest rate is 10% per

year, what is the present value of the wine?

That is, how much would you pay for the wine today?

Well, the most you would pay is $10, because $10 invested today at the

10% market rate of interest would yield you $11 at the end of the year.

In other words, the present value of next year's $11 wine is $10.

Okay.

That's an example for only a one-year investment.

Now, let's go to the other extreme by examining what's called a perpetuity.

A perpetuity is an asset, like land, that lasts forever and

pays a certain amount of dollars per year from now to eternity.

So how would you evaluate a perpetuity? Well there's a simple formula to do this.

It is

simply this.

V equals N divided by i, where V equals the present value of the land.

N is the permanent annual receipts from the land,

and i is the interest rate in decimal terms.

So, if the interest rate is 5% per year and the perpetuity yields

a $100 a year, what would be the net present value of the perpetuity?

The answer is $2000 or simply $100 divided by 05.

In fact, we can use this formula for a perpetuity to

determine what the selling price of our hypothetical apartment building should be.

But first, we have to make some further assumptions.

Let's assume that the prevailing interest rate is 5%.

Let's further assume that after expenses, our monthly rental

income of $10,000 is reduced to $5.000 or $60,000

for the year.

Based on that net rental income, and

assuming that the building will last forever,

what is the least amount of money that we should sell the building for.

The selling price should be at least $1.2 million, which

is found simply by dividing $60,000 by the interest rate.

By the way, what with the selling price be if the interest rate was 10%?

That's right, it would be only $600,000.

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