15 Investment

Question 1

What have we concluded about how firms should invest?

Answer 1

A business should keep investing in physical capital until the marginal product of capital is equal to the rental rate of capital (which is equal to the interest rate).

Question 2

What does the arbitrage equation say about investing into capital?

Answer 2

Question 3

MPK equation

Answer 3

Question 4

Why might capital prices change over time?

Answer 4

Depreciation which reduces the value of capital due to wear and tear [we add depreciation explicitly to the equation].

Technological change (think of computer prices today compared to 40 years ago).

Question 5

Arbitrage equation to accommodate for depreciation?

Answer 5

Question 6

Define user cost of capital

Answer 6

The total cost to the firm of using one more unit of capital.

Question 7

The new rule for investment.

Answer 7

A firm should invest in capital until the value of the extra output (MPK) falls to equal the user cost.

Question 8

Investment and corporate income tax.

Steps for incorporating this into our investment rule.

Answer 8

Question 9

Diagram to incorporate corporate income tax into our investment rule

Answer 9

Question 10

How can we determine how much investment is required to reach desired capital level?

Answer 10

Question 11

Derive investment capital ratio equation

(5 steps)

Answer 11

Question 12

What does investment capital ratio equation imply? What use does this equation have?

Answer 12

Investment rate depends inversely on user cost.

Microfoundation for the investment rate that we have previously assumed to be s (bar).

Question 13

Define dividend

Answer 13

A payment made by a firm to its shareholders.

Question 14

What payoffs does a financial investment have compared to depositing money?

Answer 14

1. Investor receives a dividend
2. When stock is sold, it might be at different price (greater price = capital gain, lower price = capital loss)

Question 15

What equation do we use to determine whether a firm should invest into a stock or deposit?

Answer 15

Question 16

When is a financial market informationally efficient?

Answer 16

If financial prices fully and correctly reflect all available information. When this is the case is it is impossible to make economic profit by trading.

Question 17

What are the three basic categories for investment?

Answer 17

• Nonresidential fixed investment
• Residential fixed investment
• Inventory investment

Question 18

What is nonresidential fixed investment

Answer 18

Equipment and structures purchased by businesses as well as intellectual property products (IPPs)

Question 19

What is residential fixed investment?

Answer 19

New housing purchased by households.

Question 20

What is inventory investment?

Answer 20

Goods that have been produced by firms but have not been sold. It is the change in the stock of goods at hand.

Question 21

What do we mean by production smoothing?

Answer 21

Firms tend to not drastically change production as it is costly. Instead, they produce slightly more than needed during bad times, and slightly more than needed during good times.

This is production smoothing.

It seems counter-cyclical but it is not, as inventories tend to grow in booms, and drop in busts.

Question 22

Motives that explain the pro-cyclicality of inventories

Answer 22

Pipeline theory: firms hold inventories as part of the production process itself.

Stockout avoidance: firms will hold inventories of final goods on hand to make sure that they have them available when the customer wishes.