Neoclassical model of investment Flashcards
Neoclassical investment model shows how investment depends on:
- MPK
- DMP
- Interest rate
- Tax rules affecting firms
What are the two types of firms in the NIM?
- Production firms
- Rental firms
What do production firms do?
Rent capital to produce goods and services
What do Rental firms do?
Own capital and rent it to production firms
For production firms, the formula for Change in profit is:
P*MPK-R
Reread over Cobb douglas production function
X
What does the real cost of capital depend on?
- Relative price of capital
- Real interest rate
- Depreciation rate
A firm’s net investment rate depends on:
Profit rate
Profit rate =
MPK - (Pk/P)(r+δ)
If profit rate > 0, then increasing K is:
profitable
Net investment=
ΔK
Rental firms invest in new capital when:
The benefit of doing so exceeds the cost
What are the costs of capital?
- Interest cost
- Depreciation cost
- Capital loss
How do you calculate interest cost?
i x Pk
How do you calculate depreciation cost?
δ x Pk (δ = rate of depreciation)
How do you calculate Capital loss?
-ΔPk
What’s the nominal cost of capital?
Pk(r+δ)
What is the formula for net investment?
In*Profit rate
What is δ?
Rate of depreciation
An increase in interest rate:
- Raises cost of capital
- Reduces the profit rate
- Reduces investment
An increase in MPK:
- Increases the profit rate
- Increases investment at any given rate
- Shifts I curve to the right
What are the two most important policies affecting investment?
- Corporate income tax
- Investment tax credit
Corporate tax discourages Investment because:
- If Pk rises over time, the legal definition of profit Understates true cost and overstates profit
- It doesn’t measure economic profit (depreciation cost)
What does ITC stand for?
Investment tax credit
What does ITC do?
-Reduces a firm’s taxes by a certain amount for each dollar spent on capital
Why does ITC increase the incentive to invest?
It reduces Pk, which increases the profit rate
What’s the equation for Tobin’s q?
Market value of installed capital/Replacement cost of installed capital
If Tobin’s q>1:
Firms buy more capital to raise the market value of their firms
If Tobin’s q<1
Firms don’t replace capital as it wears out
A wave of pessimism about future capital profitability would:
- Cause a fall in stock prices
- Cause tobin’s q to fall
- Shift the investment function down
- Cause a negative demand shock
A fall in stock prices would:
- Reduce household wealth
- Shift consumption function down
- Cause a negative AD shock
What are financing constraints?
Limits on the amounts that firms can borrow (or raise in financial markets)
What’s the formula for MPK?
R/P
What does pi mean?
inflation
