SEM 1 - LEC 2 - INVESTMENT

Question 1

what are the three types of investment spending

Answer 1

Non-residential fixed investment: equipment and structures purchased by businesses as well as intellectual property products.

Residential fixed investment: new housing purchased by households.

Inventory investment: goods that have been produced by firms that have not been sold.

Question 2

How do firms make investment decisions?

Answer 2

Intuition: the firm chooses the amount of capital, K, to rent and labour, L, to hire in order to maximise profits, Π, taking the wage, w, and the rental price of capital, r, as given.

The solution to the firm’s problem is to hire capital until the marginal product of capital is equal to the rental price, r, and to hire the labour until the marginal product of labour equals the wage, w.

Question 3

what’s The marginal product of capital (MPK)

Answer 3

is the extra amount of output that is produced when one unit of capital is added, holding all other inputs constant.

Question 4

what’s the production function given by

Answer 4

Question 5

what’s the equation to compute the MPK for the Cobb Douglas production function

Answer 5

Equation (3) tells us that the marginal product of capital is proportional to the average amount that each unit of capital produces, Y/K, where the factor of proportionality is 1/3, the Cobb-Douglas exponent.

The marginal product of capital depends on the ratio L/K: therefore, MPK declines as K rises.

Question 6

what’s The diminishing marginal product of capital in production look like graphically

Answer 6

Question 7

how can the maximisation problem be summarised

Answer 7

Question 8

real interest rate definition

Answer 8

The real interest rate is the amount a person can earn by saving one unit of output for a year, or equivalently the amount a person must pay to borrow one unit of output for a year.

Question 9

what is the rental price of capital equal to

Answer 9

the real interest rate

Question 10

why should a business should keep investing in physical capital until the marginal product of capital falls to equal the rental price of capital, r, which in turn equals the real interest rate, R.

Answer 10

The reasoning here can be expressed as a simple equation, a firm should invest until:
MPK = R

Question 11

Suppose the price of a machine is pk (“price of capital”).

The investor can do two things with her cash on hand: she can put money in the bank and earn the interest rate, R, or she can buy machines.

If the business is maximising profits, then at the margin both options should yield the same profit.

what does this mean

Answer 11

The left side of equation (5) shows the return from taking pk dollars and putting it into the bank for a year.
􏰀 This return is simply the interest rate earned on that sum.

The right side of equation (5) is the return from taking pk dollars and
investing in the machine.
􏰀 The investor buys the machine and earns the marginal product of capital, MPK.
􏰀 At the end of the year, the investor sells the machine.
􏰀 In addition to the marginal product, the investor also makes a capital gain or loss on the machine, depending on whether the price went up or down.
􏰀 The amount of this capital gain is ∆pk .

Question 12

what does this equation tell us

Answer 12

Equation (6) tells us that the investor should invest in the machine until the marginal product of capital falls to equal the difference between the interest rate and the growth rate of the price of machines.

Question 13

why might the price of physical capital change

Answer 13

1 the machine depreciates as it gets used: that is, depreciation reduces the amount or value of capital;
2 technological change is another reason why the price of capital goods might change.

Question 14

what’s the user cost of capital, in the equation that’s equal to MPK

Answer 14

The user cost of capital is the total cost to the firm of using one more unit of capital.

Equation (7) tells us that firms invest until the marginal product of capital falls to equal the user cost of capital.

Question 15

where is the desired level of capital stock, graphically

Answer 15

Question 16

what’s the equation for the cost of funds to the firm (interest rate R)

Answer 16

Question 17

how can you rewrite the arbitrage equation as an expression that equates the marginal product of capital to the user cost of capital for this problem:

Answer 17

Question 18

graphically, what does an increase in corporate income tax do

Answer 18

an increase in the corporate income tax increases the user cost of capital.

This requires that the marginal product of capital has to increase.

That means that the firm desires a smaller amount of capital.

Question 19

what’s the standard

capital accumulation equation:

Answer 19

Equation (10) says that the capital stock next year, Kt+1, is equal to the sum of :

Kt, is the amount of capital that we started with this year.

It, is the amount of investment undertaken using this year’s production.

d ̄Kt, subtracts off depreciation.

Question 20

how can we see how much investment the firm has to undertake over the next year in order to reach the desired level.

Answer 20

In the standard capital accumulation equation , if we replace Kt with a firm’s initial capital stock, and replace Kt+1 with the firm’s desired capital stock,

If the desired capital stock exceeds the initial level, then the firm must undertake new investment.

If the desired capital stock is less than the initial level, then the firm can invest a small amount and let the depreciation bring the capital stock down or even sell off some of its capital.

Question 21

what’s the investment rate equation

Answer 21

The desired growth rate of the capital stock, gk ≡ ∆Kt+1/Kt;

The depreciation rate, d ̄;

The user cost of capital, uc: in particular, the investment rate depends inversely on the user cost → a higher user cost of capital leads to a lower investment rate.

Question 22

what’s the equation for R, if we invest in stock

Answer 22

Question 23

what’s the price of the stock equation

Answer 23

Question 24

what does this equation tell us

Answer 24

This equation says that the price-earnings ratio should equal the dividend-earnings ratio, divided by R − g .

Question 25

how can we express Tobins q

Answer 25

Question 26

what happens if tobins q is larger or smaller then 1

what predictions can we make from this

Answer 26

When q is larger than 1, the stock market signals that the value of the firm is greater than its capital, and the firm should invest in more capital.

When q is less than 1, the value of the firm is less than the value of its capital, and we would expect the firm to be “disinvesting”.

This leads to two basic predictions:
1 The value of a firm’s q should be close to 1.
2 The value of q should be a useful predictor of firm-level investment.

Question 27

what’s financing constraints

Answer 27

limits on the amount they can raise in financial markets.

Financing constraints can prevent firms from undertaking profitable investments.

Question 28

what’s the effect of a short recession on investment spending

Answer 28

A recession reduces employment, the rental price of capital, and profits.

If firms expect the recession to be short-lived, however, they will want to continue investing, knowing that their investments will be profitable in the future.

For firms that can raise funds in financial markets, the recession should have only a small effect on investment.

The opposite is true for firms that face financing constraints.

The fall in current profits restricts the amount that these firms can spend on new capital goods and may prevent them from making profitable investments.

Thus, financing constraints make investment more sensitive to current economic conditions.

Question 29

whats the Cobb Douglas production function

Answer 29