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Nominal cost PK
i PK PK PK PK i
of capital PK
CHAPTER 18 Investment 3
The cost of capital
R PK PK
Profit rate = r = MPK r
P P P
If profit rate > 0,
then increasing K is profitable
If profit rate < 0, then the firm increases profits by
reducing its capital stock
(i.e., not replacing capital as it depreciates)
CHAPTER 18 Investment 5
Net investment & gross investment
Hence,
net investment = K I n MPK PK P r
where In[ ] is a function that shows how
net investment responds to the incentive to invest.
Total spending on business fixed investment equals
net investment plus replacement of depreciated K:
gross investment K K
I n MPK PK P r K
CHAPTER 18 Investment 6
The investment function
I I n MPK PK P r K
An increase in r : r
raises the cost
of capital
reduces the r2
profit rate
and reduces r1
investment:
I
I2 I1
CHAPTER 18 Investment 7
The investment function
I I n MPK PK P r K
An increase in MPK r
or decrease in PK/P
increases the
profit rate
increases
investment at any r1
given interest rate
shifts I curve to I
the right. I1 I2
CHAPTER 18 Investment 8
Tobins q
CHAPTER 18 Investment 10
The stock market and GDP
CHAPTER 18 Investment 11
The stock market and GDP
CHAPTER 18 Investment 12
The stock market and GDP
CHAPTER 18 Investment 13
Alternative views of the stock market:
The Efficient Markets Hypothesis
Efficient Markets Hypothesis (EMH):
The market price of a companys stock is the fully
rational valuation of the company,
given current information about the companys
business prospects.
Stock market is informationally efficient:
each stock price reflects all available information
about the stock.
Implies that stock prices should follow a random
walk (be unpredictable), and should only change
as new information arrives.
CHAPTER 18 Investment 14
Alternative views of the stock market:
Keyness beauty contest
CHAPTER 18 Investment 15
Alternative views of the stock market:
EMH vs. Keyness beauty contest
Both views persist.
There is evidence for the EMH and random-walk
theory (see p.498).
Yet, some stock market movements do not
seem to rationally reflect new information.
CHAPTER 18 Investment 16
Financing constraints
Neoclassical theory assumes firms can borrow to
buy capital whenever doing so is profitable.
But some firms face financing constraints:
limits on the amounts they can borrow
(or otherwise raise in financial markets).
A recession reduces current profits.
If future profits expected to be high,
investment might be worthwhile.
But if firm faces financing constraints and current
profits are low, firm might be unable to obtain funds.
CHAPTER 18 Investment 17
CHAPTER 18 Investment 18
Residential investment
The flow of new residential investment, IH ,
depends on the relative price of housing PH /P.
CHAPTER 18 Investment 19
How residential investment is
determined
(a) The market for housing
PH
Suppl Supply
Supply and
and demand
demand for
for
P y houses
houses determines
determines the
the
equilib.
equilib. price
price of
of houses.
houses.
The
The equilibrium
equilibrium price
price of
of
houses
houses then
then determines
determines
residential
residential investment:
investment:
Demand
KH
Stock of
housing capital
CHAPTER 18 Investment 20
How residential investment is
determined
(a) The market for housing (b) The supply of new housing
PH PH
Suppl
P y P
Suppl
y
Demand
KH IH
Stock of Flow of residential
housing capital investment
CHAPTER 18 Investment 21
How residential investment responds
to a fall in interest rates
(a) The market for housing (b) The supply of new housing
PH PH
Suppl
P y P
Suppl
y
Demand
KH IH
Stock of Flow of residential
housing capital investment
CHAPTER 18 Investment 22
Stylized facts:
Housing constitutes a significant share
of household expenditure as well as
total wealth.
Usually, the value of the residential
Why is capital stock is larger than that for
business capital, and usually, the
Housing annual market value of residential
investment is larger than that for
market business capital investment
importan Significant fluctuations in housing price
would imply significant fluctuations in
t? wealth, and thus potentially significant
household wealth effects. housing is
not just another consumption good.
The market value of the US residential
property stock is approximately equal
to the annual average GDP.
Linkages Inflation
Fiscal Consumptio
n
Housi
ng
Prices
Investme
Banking
nt
The typical residential housing transaction is
financed largely with borrowed money.
The use of such leverage to purchase an asset
magnifies the risk assumed by the buyer.
If the value of the asset subsequently drops, as in
a burst bubble, the debt incurred to buy the asset
remains in place
The buyer must still repay the loan in full. If the
debt exceeds the assets market value, refinancing
options are limited.
If the debt is very large relative to the buyers
income, repayment can strain the buyers
finances, forcing a reduction in other spending.
And if the strain becomes too great, the buyer
may be forced to default, shifting some or all of
the loss to the lender or the taxpayer if the loan is
government insured.
A link between credit and house prices
may arise via housing wealth and
collateral effects on credit demand and
credit supply and via repercussions of
credit supply fluctuations on house prices.
A permanent increase in housing wealth
leads to an increase in household
spending and borrowing when
homeowners try to smooth consumption
over the life cycle.
There is also a collateral effect of house
prices emanating from the fact that
houses are commonly used as collateral
for loans
.As a consequence, higher house prices
induce homeowners to spend and borrow
more.
The most direct effect of house price
fluctuations on economic activity is via
residential investment. An increase in
house prices raises the value of
housing relative to construction costs,
GDP Employment
20 13
% %
Construction Construction
(8.2%) (11.3%)
Real Estate Real Estate
Drivers of Real Estate
Sector
PropTiger Charts
Singapore's per capita income is the highest in Asia, but home
prices are only moderately higher than that of India's
In India, the ratio of home prices to income is high while gross rental yield is low.
Motives for holding inventories
1. production smoothing
Sales fluctuate, but many firms find it cheaper to
produce at a steady rate.
When sales < production, inventories rise.
When sales > production, inventories fall.
CHAPTER 18 Investment 34
Motives for holding inventories
1. production smoothing
2. inventories as a factor of production
Inventories allow some firms to operate more
efficiently.
samples for retail sales purposes
spare parts for when machines break down
CHAPTER 18 Investment 35
Motives for holding inventories
1. production smoothing
2. inventories as a factor of production
3. stock-out avoidance
To prevent lost sales when demand is higher
than expected.
CHAPTER 18 Investment 36
Motives for holding inventories
1. production smoothing
2. inventories as a factor of production
3. stock-out avoidance
4. work in process
Goods not yet completed are counted in
inventory.
CHAPTER 18 Investment 37
Inventories, the real interest rate,
and credit conditions
Inventories and the real interest rate
The real interest rate is the opportunity cost of
holding inventory (instead of, e.g., bonds)
Example: High interest rates in the 1980s
motivated many firms to adopt just-in-time
production, which is designed to reduce
inventories.
Inventories and credit conditions
Many firms purchase inventories using credit.
Example: The credit crunch of 2008-09 helped
cause a huge drop in inventory investment..
CHAPTER 18 Investment 38
Assume that there is a stable relationship
between the total capital stock, K, and
total GDP, Y.
Now suppose that this ratio, known as the
capital-output ratio, is defined as k.
Assume that the national saving ratio, s,
is a fixed proportion of national output.
Assume that total new investment is
determined by the level of total savings.
Savings, S, is some proportion, s, of
national income, Y, such that S = s
(Y)
Investment, I, is defined as the
change in capital stock, K, such that
I = K
K = kY K = k (Y) I = k (Y)
Since total national saving, S, must
equal total investment, I, then S =
k (Y)
Dividing both sides by Y we get
s/k = Y/Y
The rate of growth of GDP (Y/Y) is
determined jointly by the national
saving ratio (usually expressed as a
percentage), s, and the national
capital-output ratio (expressed as an
integer), k.
k is the ICOR or incremental capital
output ratio
Defined as the inverse of the
marginal productivity of capital.
Assume that the national capital-
output ratio of a country is 3 and that
the aggregate savings ratio is 6% of
GDP, then it follows that this country
can grow at a rate of 2% per year.
capital-output ratio = 3
desired % growth in GDP = 5%
Investment (as % of GDP) required to
achieve this growth = 15%
I (as % GDP) required (15%) S (12%) =
3% of I required from external sources
Target growth rate times ICOR gives
investment requirements