Document Sample

```					                           Investment
businesses’ spending on equipment and structures for
use in production

 Residential investment:
purchases of new housing units
(either by occupants or landlords)

 Inventory investment:
the value of the change in inventories
of finished goods, materials and supplies, and work in
progress.

CH. 17 Investment
slide 0

Components of Total Investment

slide 1

 The standard neoclassical model of investment
 Assume prices are fixed and always to 1, and
there is no inflation (like in classical model)
 Shows how investment depends on
– MPK
– interest rate
– tax rules affecting firms

1.   Production firms rent the capital they use to produce
goods and services (DEMAND).
2. Rental   firms own and create capital, rent it out to
production firms (they make the decision of how much
to invest) (SUPPLY)

CH. 17 Investment
slide 2

1
Production firms and Capital demand

Cobb-Douglas production:                Y  A K  L1
Production firms maximize Y-RK-WL

This implies that capital demand is:
R = MPK = A(L/K)

The equilibrium R would increase if:
• K (due, e.g., to earthquake or war)
• L (due, e.g., to pop. growth or immigration)
• A (technological improvement, or deregulation)
CH. 17 Investment
slide 3

firms’
Capital supply: Rental firms’ investment decisions
Rental firms invest in new capital when the benefit of doing so exceeds
the cost.

The benefit (per unit capital): R

Components of the cost of capital:
• interest cost: r
• depreciation cost: 
Total cost of capital = r + 

Profit rate = R – (r +  S = f (Profit Rate)

If profit rate > (<) 0, then it’s profitable for firm to increase (decrease) K

CH. 17 Investment
slide 4

The capital rental market

R
 SUPPLY: Rental                                           KS(R-(r+))
firms
 DEMAND:
Production firms
decide how much                                                    KD(R)
capital to rent.

equilibrium
rental rate                                       K
capital
stock
CH. 17 Investment
slide 5

2
The investment function of the rental firms

I = In [ MPK – ( r + ) ] + K

r

I

CH. 17 Investment
slide 6

Tobin’
Tobin’s q
Market value of installed capital
q 
Replacement cost of installed capital
If denominator is equal to 1, q moves together with the stock market
Tobin: firms base their investment decisions on q
- If q > 1, firms buy more capital to raise its market value
- If q < 1, firms do not replace capital as it wears out.

Relationship with neoclassical theory?
 q depends on the current & expected future profits of capital.
 If MPK > cost of capital,
then profit rate is high, which drives up the stock market value of
the firms, which implies a high value of q.
 If MPK < cost of capital, then firms are incurring losses, their stock
market value falls, and q is low

CH. 17 Investment
slide 7

The stock market and GDP

1. Pessimism about future profitability of capital would
• cause stock prices and Tobin’s q to fall
• shift the investment function down

2. A fall in stock prices would
• reduce household wealth and consumption

technological progress and long-run economic growth.
This implies that output will be expanding more slowly

CH. 17 Investment
slide 8

3
The stock market and GDP
60                                                             10

previous four quarters
50

% change over
previous four quarters

40                                                             8

Real GDP,
% change over
Stock prices,

30
6
20
10                                                             4

0
2
-10
-20                                                            0
-30
-2
-40
-50                                                            -4
1965     1970   1975   1980   1985     1990   1995   2000
Stock prices
Real GDP
slide 9

(2) Residential investment
 The flow of new residential investment, IH , depends
on the relative price of housing,
P H /P .

 PH /P is determined by supply and demand in the
market for existing houses.

CH. 17 Investment
slide 10

How residential investment is determined

(a) The market for housing               (b) The supply of new housing
PH                       Supply                     PH
P                                                   P
Supply

Demand
KH                                           IH
Stock of                     Flow of residential
housing capital                    investment
CH. 17 Investment
slide 11

4
How residential investment
responds to a fall in interest rates

(a) The market for housing         (b) The supply of new housing
PH           Supply                     PH
P                                       P
Supply

Demand
KH                                     IH
Stock of                    Flow of residential
housing capital                   investment
CH. 17 Investment
slide 12

The tax treatment of housing
 The tax code subsidizes home ownership by allowing
people to deduct mortgage interest.

 The deduction applies to the nominal mortgage rate 
subsidy higher when inflation and nominal mortgage
rates are high

 Subsidy causes over-investment in housing

 But eliminating the mortgage interest deduction would
be politically difficult.

CH. 17 Investment
slide 13

(3) Inventories
1% of GDP (but very volatile)

Why do firms hold inventories?
1. production smoothing
Sales fluctuate, but firms prefer to produce at steady rate.
When sales < (>) production, inventories rise (fall)

2. inventories as a factor of production

3. stock-out avoidance
To prevent lost sales in case of higher than expected demand.

4. work in process         Goods not yet completed are counted as
part of inventory.
CH. 17 Investment
slide 14

5
The Accelerator Model

 Notation:
N = stock of inventories
N = inventory investment
 Assume firms hold inventories proportional to their
output N = Y,

Result:
N =  Y
Inventory investment proportional to change in output.
In the data =0.2

CH. 17 Investment
slide 15

Inventories and the real interest rate

 The opportunity cost of holding goods in inventory: the
interest that could have been earned on the revenue
from selling those goods.

 Hence, N = f (R)

 Example:
High interest rates in the 1980s motivated many firms to
adopt just-in-time production, which is designed to
reduce inventories.

CH. 17 Investment
slide 16

6

```
DOCUMENT INFO
Shared By:
Categories:
Stats:
 views: 21 posted: 6/8/2010 language: English pages: 6
How are you planning on using Docstoc?