Midterm Topic 7

Question 1

key tradeoff for firms b/w investment and saving

Answer 1

tradeoff between accumulating capital used for production and yielding production income (investment) vs. acquiring other real assets or financial assets yielding interest income (saving).

[the greater the returns on future capital and production income, the greater the incentives to acquire capital assets instead]

Question 2

present value

Answer 2

value of a future payment in terms of today’s currency. It is equal to the amount of money that must be invested today at the given real interest rate to be worth the specified future amount

Question 3

relationship between real interest rate and investment/national investment

Answer 3

investment inversely related to real interest rate.

as real interest rate increases, present value for future benefits declines (formula) –> investment becomes less likely.

Question 4

real interest rate

intuitive explanation for what happens to investment

Answer 4

real interest rate = return on financial assets.

as return on financial assets increases, the opportunity costs of capital stock (real assets) investments increase and make capital investments less likely.

Question 5

K (t+1) =

Answer 5

K(t) - d K(t) + I(t)

Question 6

Investment motive

Answer 6

I(t) = K(t+1) - K(t) + dKt

1. increase in capital stock–> K(t+1) > K(t)
2. replacement of worn out capital: dK(t)

Question 7

investment alternatives

Answer 7

a firm can either acquire

1. financial assets–return described by real interest rate (1+r)
2. real assets (firm’s capital stock) with a return of 1 - d + MPk(fut), where 1 -d is the amount of machinery in the future and MPk(fut) is the expected increase in future output.

Question 8

investment decision

Answer 8

Driven by firms’ expectations about the future.

If the extra output from a new machine is greater than the real interest rate for financial assets plus the machine’s value loss in the future (MPk(fut) > r + d), the it’s good to invest/purchase machinery.

Question 9

temporary shock

Answer 9

affects the economy during one period and affects either the current period OR the future period [either Y1 or Y2]

Question 10

marginal propensity of consumption

Answer 10

temporary shocks: when MPC(t) < 1, a household increases current consumption by less than a dollar if current income increases by a dollar.

permanent shocks: MPC(p) = 1. a household knows the current good news will also be present in the future and will not save increased current resources for the future as future resources will improve too.

Question 11

permanent productivity shock

Answer 11

affects both current income, Y1, and future income, Y2

Question 12

real interest rate in small open economies vs. closed economies

Answer 12

closed economies: endogenously determined by national saving and investment

small open economies: exogenously given by the world funds market