Investment

Question 1

Types of investment

Answer 1

Business fixed
Residential
Inventory

Question 2

Business fixed investment

Answer 2

Fixed assets used in present and future production

E.g factories, chairs, computers

Question 3

What does the neoclassical model of investment look at, and how?

Answer 3

Costs and benefits of owning capital goods.

How? By considering at 2 types of firms, production and rental firms

Question 4

Production firms vs rental firms

Answer 4

Production firms produce G&S using rented capital

Rental firms rent capital to production firms

Question 5

Production firms problem in the neoclasical model
(how do they decide how much capital to rent?)

Answer 5

They choose how much capital to RENT by comparing cost and benefits of each unit of capital

Question 6

How do they determine the cost/benefit of each unit?

Answer 6

They rent at cost R, and sell at price P.

Real cost if R/P.
Real benefit is MPK. (Which is diminishing in SR)

They will rent up until real cost=real benefit, MPK=real rental price of capital. (MPK=R/P)

Question 7

Recall capital market diagram

Answer 7

Capital supply constant in S.R
(rmb depreciation holds constant i=δk)

MPK/capital demand downward sloping as MPK falls as capital increases.

Question 8

What is the MPK equilibrium in CD form (where they hire up to)

Answer 8

MPK= R/P = vA(L/K) to the 1-v

So R/P=vA(L/K) to the 1-v

Question 9

What does this equilibrium for production firms equation show?

(explain effect of a fall in K, increase in L, increase in A)
and diagram?

Answer 9

If K low, higher real rental price.
E.g after an earthquake, k is in higher demand so rental price increases. (Makes sense as when in short supply, price high)

And if L high, higher real rental price.
E.g an increase in AD, we increase labour demand, also driving demand for capital so rental price rises.

Higher A (tech) , higher real rental price
More productive so firms demand more capital so rental price rises.

Question 10

Firm 2: Rental firms, what is the benefit?

What factors are considered in costs? (3)

Answer 10

Benefit = R/P for each unit

Factors considered in costs:
- Financing cost to purchase the capital (nominal i). Even if not borrowing, i is opportunity cost (putting in banks)

• Price of capital can change whilst on loan (up or down e.g up central London properties, down for 2nd hand cars)
• Depreciation of the capital whilst on loan

Question 11

So how do we equate the cost of owning capital (accommodating for those 3 considerations)

2. How do we make cost a function of the real interest rate, rather than nominal?

Answer 11

Cost of capital = iPk - ΔPk + δPk

Can be rewritten as
Pk(i-ΔPk/Pk+δ)

2. Let growth rate of price ΔPk/Pk = π (inflation)
   Pk (i - π + δ)
   Pk (r + δ)

Pk is price of capital
i is nominal interest rate
δ is depreciation rate.
r is real interest rate (i-π)

Rental firms cost of capital that they then rent out

Question 12

So cost of capital is
Pk (r+δ)

What is the real cost of capital ?

Answer 12

(Pk/P)(r+δ)

So just divide Pk by P to find relative price of capital

Question 13

How do they decide whether to increase/decrease capital stock?

Answer 13

Real profit per unit determines net investment

Profit = Rev - Costs
R/P - (Pk/P)(r+δ) or
MPK - (Pk/P)(r+δ)

So profit exists if MPK> real cost of capital

Question 14

Third type of firms

Answer 14

Both renters and purchasers

E.g airlines own planes and also rent their planes

Question 15

For this firm, what is the benefit of an additional unit of capital, and what is the cost?

Answer 15

Benefit is MPK
Cost is cost of capital

Question 16

From this, what is net investment for type 3 firm?

Answer 16

ΔK= In (MPK - (Pk/P)(r+δ)

In (net investment) is a function of benefits MPK and costs (Pk/P)(r+δ) showing how net investment respoinds to the incentive to invest.

Question 17

How do firms react to depreciation, and how does the investment function change?

Answer 17

Firms conduct replacement investment to keep K constant. (Replacement investment to Make ΔK=0)

I = In [MPK - (Pk/P)(r+δ)] + δK

ΔK is net investment
I is gross investment (where we add replacement investment)

Different previous, where net investment includes depreciation but not the replacement investment!!!

Question 18

What is bigger, net or gross investment

Answer 18

Gross is bigger.

Note: as diagram pg 11 shows, net investment is always smaller than gross investment as we include replacement investment, thus making gross investment bigger

Question 19

Relationship between I (gross investment) and r: show this by interpreting a fall in r

Answer 19

I = In [MPK - (Pk/P)(r+δ)] + δK

A decrease in r, lowers cost of capital, increasing profit, and thus incentive to accumulate to accumulate capital (In) , so gross investment I increases.

Makes sense as essentially when low interest, I increases.

Question 20

Summary:
What happens to capital accumulation if MPK> cost of capital, or MPK=cost

Answer 20

MPK>cost, capital increases
MPK<cost, capital declines

Adjusts until MPK = (Pk/P)(r+δ)
So ΔK=0 (net investment = 0) , and I=δk (gross investment I=δk)

Question 21

Tobin’s q

Answer 21

Looked at link between fluctuations in stock market and fluctuations in investment.

He proposed firms base investment on q ratio

Question 22

Q ratio and how to interpret (if >1 , <1)

Answer 22

Q= Market value of capital / replacement cost of capital

If q>1= market value>replacement cost: acquiring more capital increases value of the firm. At the same time remember MPK falls as K increases (DMR) so we acquire till q=1

If q<1 - market value<replacement cost, so we should reduce capital (or not replace), so MPK increases as K falls, we reduce until q=1.

Question 23

What does market value of capital (from stock market valuation) show

Answer 23

Shows current and expected future profitability of a firm’s capital stock.

Question 24

What happens to share price and q ratio if MPK>cost of capital or <cost

Answer 24

MPK>cost Firms make profit on installed capital, creating higher share price (since firms are in a good state) and higher q.

If less, firm incur losses on installed capital, lower share price (as firms in worse state), lower q.

Question 25

For Tobin’s q (an indicator of the incentive to invest) to be useful, what needs to happen? What hypotheis shows this?

Answer 25

To be useful, stock market fluctuations need to be rational

Efficient markets hypothesis

Question 26

Efficient markets hypothesis

Answer 26

Market price of a companys stock IS a fully rational valuation of the company

Question 27

Why is market price of stock a rational valuation? (2)

Answer 27

Share price is determined by supply demand.

Share price reflects all available information

Question 28

What trend do share price follow?

Answer 28

Share prices follow a random walk, only change with news/new information (unpredictable)

Question 29

So CHANGES in share prices are impossible to predict with available information since only change with unpredictable news…

So how do fund managers beat the market? (3)

Answer 29

Information advantages (fund managers may have better info than average investor, illegal insider info can exist too)

Good luck

EMH may not be correct

Question 30

Keynes Beauty Contest questions validity of stock market rationality

Answer 30

When creating valuations, we anticipate the average opinion of the average opinion.

I.e speculate upon the valuation others attach, rather than the true value.
E.g overpay as believe it will increase in value. (Just like how i wanna buy chrome hearts above resale already, to anticpate being able to sell for more)

Question 31

So using KBC, what are share prices subject to? (2)

Answer 31

Waves of optimism and pessimism
I,e animal spirits, price bubbles can form (valuation has become detached from true value)

Thus making share prices unreliable, and Tobin’s q and EMH invalid.

Question 32

Financing constraints - it can be hard to access.
When do banks provide funding

Answer 32

If MPK> cost.

Question 33

What about firms that can’t borrow, e.g small firms.

What do these borrowing constrained firms decisions to invest depend on?

Answer 33

Investment decisions depend on cash flow rather than profitability.

Question 34

So tobin’q relies on values being accurate. (EMH)

KBC questions this

Question 35

Why is investment function downward sloping

What if r falls

Answer 35

R y axis
Investment I x axis

Downward sloping since investment increases as r falls.

if r falls, profit rate and i increases. so a shift.

Question 36

when does the investment function shift in the diagram

Answer 36

If profit rate changes
(remember I = In [MPK - (Pk/P)(r+δ)] + δK)

and MPK = R/P = vA(L/K) to the 1-v
so if MPK increases, it shifts.