Macro - Week 5

Question 1

Investment punchlines: What is investment determined by?

Answer 1

cost of capital and its marginal revenues.

Question 2

Basic model implies implausible behaviour for investment: need adjustment costs.

Answer 2

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Question 3

Tobin’s q

Answer 3

• measures market value of capital over its replacement value: important determinant of investment.
• If the market value reflected solely the recorded assets of a company, Tobin’s q = 1.0.
• If Tobin’s q > 1, then market value > value of recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. High Tobin’s q values encourage companies to invest more in capital because they are “worth” more than the price they paid for them. If a company’s stock price (which is a measure of the company’s capital market value) is $2 and the price of the capital in the current market is $1, so that q > 1, the company can issue shares and with the proceeds invest in capital, thus obtaining economic profit.
• On the other hand, if Tobin’s q < 1, market value < recorded value of assets. This suggests that the market may be undervaluing the company, or that the company could increase profit by getting rid of some capital stock. The market seems to be saying that the deployed real assets will not earn a sufficient rate of return and that, therefore, the owners of such assets must accept a discount to the replacement value if they desire to sell their assets in the market. If the real assets can be sold off at replacement cost, for example via an asset liquidation, such an action would be beneficial to shareholders because it would drive Q ratio back up toward parity. In the case of the stock market as a whole, rather than a single firm, the conclusion that assets should be liquidated does not typically apply. Instead, when market-wide Q is less than parity, investors are probably being overly pessimistic about future asset returns.
• Tobin’s insights show that movements in stock prices will be reflected in changes in consumption and investment, although empirical evidence shows that the relationship is not as tight as one would have thought. This is largely because firms do not blindly base fixed investment decisions on movements in the stock price; rather they examine future interest rates and the present value of expected profits.
• other elements that may affect the value of q:
  
  • Market hype and speculation, e.g. analysts’ views of the prospects for companies or speculation such as bid rumors.
  • intellectual capital

Question 4

Investment and cost of capital

Answer 4

• What is the rental price of capital? Difficult to observe since most firms do not rent capital but own it.
• Consider a firm that owns a unit of capital and suppose that the real market price of the capital is pK. Keeping it leads to opportunity costs:
  
  • Forgone interest: r pK, where r is the real interest rate;
  • Capital depreciation: pK, where is the depreciation rate;
  • Changes in the price of capital: _ pK.
• Therefore: r_K = rp_K + deltap_K - p_K (dot on p)

Question 5

Adjustment costs

Answer 5

Question 6

Tobin’s q & standard model: solving the model

Answer 6

Question 7

Tobin’s q & standard model: FOC’s & transversality condition

Answer 7

Question 8

Tobin’s q & standard model: analysis

Answer 8

Question 9

the deltaK=0 line

Answer 9

Question 10

the deltaQ=0 line

Answer 10

Question 11

steady state and saddle path

Answer 11

Question 12

permanent productivity shock (F’(K) increases)

Answer 12

Existing capital becomes more valuable, which attracts investment.

Question 13

permanent productivity shock (F’(K) increases, then decreases)

Question 14

permanent interest rate shock (r decreases)

Answer 14

Not only short-run, but also long-run interest rates affect investment decisions.

Question 15

investment subsidy

Answer 15

note on temporary subsidy: q falls less on impact: investment in the short run is higher

Question 16

Summers: is investing increasing in q?

Answer 16

Question 17

Cummins, Hassett, and Hubbard (1994)’s Test

Answer 17

• The tax reforms of 1962, 1971, 1982, and 1986 had very different effects on the tax benefits of different types of investment.
• Because the compositions of industries’ capital stocks differ greatly, the result was that the reforms’ effects on the after-tax cost of capital differed greatly across industries.
• Cross-industry regressions in the tax-reform years lead to an estimate of b=0.5
• Much more plausible figure than the one obtained by Summers: adjustment costs for I=K = 0:2, are equal to 4% of the value of the capital stock.