Interest Rates

(Chapter 15 BH)

Why Don’t They Buy…

• Energy efficient appliances, insulation, windows and so on when they redo their homes?

• additional cost $4K upfront• utility bill decrease $744• CO2e saved about 11,800 per year.

Interest Rate

• principle• interest payment• interest rate = payment/principle– (these days often daily, but expressed as a yearly

equivalent)

• Future Value: The future value of 100 at r% for t years is the amnt of money you will have in t years if invested at r%: principle*(1+r)^t

• Present Value (PV). Value today of payments in the future.

• PV = (1+r) -t * FV• PV of annual payment of AV starting in one

year is AV/r.

Back to energy saving

• If interest is 5% and savings last forever• PV of savings is 14,880• Cost is 4047• Present Net Value is 10,833.• On the other hand if the savings only last 5

years the PV of savings is 3221 (look at book for calc) and PNV = -826.

• Could also try 10% interest rate.

Invest and interest

• Obviously high interest and quick depreciation militate against investments.– Even socially nice ones.

14-7 © 2011 Pearson Addison-Wesley. All rights reserved.

Figure 14.2: The Effect of Time on $1,000 in Future Value.

Market interest rates• Nominal vs. Real– inflation– CPI

• If you use real interest rates make sure you are using real prices for the benefits– e.g. nominal electric prices rose by 5%/year, but so

did the price of other goods (CPI). – Use nominal prices and nominal interest rate– Use real prices (price/CPI) and real interest = r minus

the inflation rate.– Get same answer either way.

Borrowing and Saving

• Financial system gets paid to round up your savings and lend them to someone.

• Difference in rates compensates them for their work and also the risk of the loan, which they bare and you do not.

Risk

• Treasury bonds are really as guaranteed as you can get. You will get your $ back. Hence no risk.

• Corporate bonds—more risk so you get a higher rate of return to pay you for taking the risk.

• Stocks—S&P 500 is a good index (Russel 2000 is a little better). Higher rate of return yet, but you can gain or lose 4% of your money in one day!

Risk Reality

• 1. If you look only at the post war period then stocks look great relative to bonds. But if you include pre-war bonds and stocks look more similar in their returns.

• 2. Your greatest risk is your human capital risk. Disability is not so uncommon and has a far greater effect on your lifetime income than the stock market.

Price of Risk

• (Advanced Topic)• Investor can hold the S&P itself. Eliminates

idiosyncratic risk. Intel goes up and AMD down. Together less risk than alone.

• Stocks are priced based on their tendency to rise and fall with the market (S&P).

• Ones that go up and down in market cycle faster than the market have the most risk.

Public Projects

• I want to build a dam. Benefits from electricity, irrigation and flood control all come in the future. Costs all come now.

• High interest rate = little PV benefits• Low interest rate = big PV benefits• Which interest rate is “right?”

Social Discount Rate

• Pure: I believe that all people are too present oriented and want my government to compensate for that. That is, I wouldn’t invest in the dam, but I think they should.

• Confused: Global warming is an externality. I want it stopped. I want government to stop it. Here I don’t see why they should use a lower interest rate—they should just price the externality.

Risk in Public Projects

• There is a way of stopping global climate change. (a hypothetical)

• It’s expected costs are a little larger than its expected benefits at the market rate of interest (around 10%, the return, nominal, on the s&p 500)

• Would you do it anyway?– Do you insure your house against fire?– Would you buy planet fire insurance?

Vexed Question

• I hold with the conservatives:• for the same type of project, the gov’t and the

private sector should be using the same rates

Socially Responsible Investing

• A bet against dirty companies.– Tobacco; nuclear; alcohol; defense; – Good record of compliance

• Loses diversification• Costs money to do the “screens”• Gives investors a “warm glow”; might work

for workers too—but nuclear employees might think that nuclear is cool.

Benefit Cost Analysis

• “if the benefits to whomsoever they may accrue are in excess of the estimated costs.”

• Criteria for public projects

Tellico Dam

• Outline of story: (Chapt 17)• Dam was mostly built• Snail darter discovered• ESA invoked• G_d squad—interagency group to determine

whether to allow extinction.• Found defect in BCA• Dam built and darter survived• Development benefits never happened.

Ratio?

Max PNV not ratio. When limited funds, then pick projects with highest ratio. With 100million is 10 small better than 5 large? (Not far fetched– a bond to fund water saving projects in CA—projects ranked by BCR)

Benefits

• Area under demand– could be market good, like corn– could be non-market good like whales

costs

• usually engineering estimates for structures• got to get all costs– drowned land– drowned Indian villages and historic sites– endangered species– and so on.

Alternatives

• Big or little dam?– Max concrete s.t. BCA > 0– Max BCA

• When?– Now– Later– Is there an uncertainty that will be resolved if you

wait? Is the project marginal with 10 years ago energy prices? Would it be a go now?

To BCA or Not to BCA

• It is a screen to get rid of truly awful projects.• Like an EIS/EIR it can be manipulated.• If permitted it could be litigated.• Requiring a BCA for environmental regulations is

controversial. In practice we do that here in CA and still have the toughest environmental laws.

• Perhaps it is an important part of being able to have tough environmental laws—efficient ones are cheaper.