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.
