Expectations Part 3 Flashcards
Gross Capital Formation
Producers’ outlays on additions to the capital assets of the economy + net changes in the level of inventories
Give examples of additions to capital assets?
- New buildings
- Vehicles
- Plant and Machinery
- Infrastructure etc
Why does investment matter?
- Investment is extremely volatile on demand side
- Investment spending is a primary link through which monetary policy affects the economy
What factors do investment decisions depend on?
- Current sales
- Current real interest rate
- Expectations of future rates and sales
How do firms decide whether or not to build new machinery or build new plant?
- If present value of profit exceeds the cost, they invest and vice versa
It
investment in period t
π t
profit per machine for the economy
V (πt)
expected present value of future profit per unit of capital
rt
real interest rate in period t
ઠ
rate of depreciation
Describe the investment decision.
- Investment depends positively on current profits and PV of future profits
- Investment depends negatively on current and expected real interest rates and also depreciation
What determines profit per unit of capital?
- Level of sales
- Existing capital stock
When should firms invest?
When the financial value of a unit of their capital exceeds the cost of an additional unit of capital - q > 1
Tobin’s q
q = financial value of firm / replacement cost of installed capital
What is the financial value of a firm?
Stock market value - dependent on current and expected future profits
What is replacement cost of installed capital?
Actual cost to replace the firm’s existing capital goods at the item the stock was issued
How does Tobin’s q describe how pessimism about future probability caused negative demand?
- Stock prices fall due to pessimsm
- Value of firm falls
- q falls
- investment decreases