T2: Topic 4: Investment Flashcards
See
graphs/data page 2 slides
3 components of investment, and what they are?
1) Business fixed investment: includes equipment/structures firms purchase to use in production process
2) Residential investment: includes owner occupied housing and housing purchased to rent out
3) includes goods which firms put aside for storage (eg. WIP, supplies, materials)
What do firms tend to run down during recessions? (2) What does this mean
Inventories (see data page 3)
Pre-recession investments
Pro-cyclical tf +ve association between I and GDP
Note
I more volatile than C
Explain business fixed investment in detail?
The largest component of investment spending (approx. ¾ of the total); we therefore spend the most time on this component.
‘Business’: Firms investing to facilitate future production.
‘Fixed’: Firms hold onto this capital; in contrast to inventories which will be sold or used within a short period of time.
Examples: Factories, company cars, computers, office furniture.
2 types of firms considered by Neoclassical Model of Investment (NMoI)?
1) Production firms = produce goods and services using rented capital
2) Rental firms = purchases capital to rent it out to production firms
How do production firms choose how much capital to rent?
By comparing the cost and benefit of each unit of capital
Rents at R/unit
Sells at P/unit
tf Real cost of 1 unit of capital=R/P
Draw a production firms’ capital supply and MPk on a diagram?
See notes
For a CD PF, what is capital’s normal rough share of output?
1/3 (alpha=1/3)
Interpretation of 𝑀𝑃𝐾 = 𝑅/𝑃 = 𝛼𝐴(𝐿/𝐾)^(1−𝛼) ? (3)
1) The lower the stock of capital, the higher the real rental price of capital
2) The greater the amount of labour employed, the higher the real rental price of capital (comp. goods)
3) The better the technology, the higher the real rental price of capital
Benefit of owning K for rental firms?
R/P per unit
3 costs of owning capital for rental firms?
1) If firm borrows to buy K, it incurs a nominal interest rate, i; even if they don’t borrow, i still represents opportunity cost
2) Price of K can change whilst out on loan
3) Capital depreciates whilst out on loan
What does Pk/P represent in real cost of capital equation?
The relative price of goods
How do rental firms determine whether to increase/decrease amount of capital stock owned?
Real profit/unit determines their net investment
If MP(k)>cost of capital firm profits
Prove the profit rate equation for rental firms
see notes
Note
In reality firms are likely to be part type 1 and part type 2 firms
tf benefit=MP(k), cost=cost of capital
Difference between gross investment and net investment? What does this mean when they are compared?
Gross investment includes depreciation, net investment doesn’t.
Means that gross investment is always the higher value/line if on a graph
Why does gross investment get a different value to net investment?
gross investment counts ‘replacement investment’ as investment
Explain the relationship between I and r, and draw graph?
Decrease r -> decrease P(k) -> increase profit from owning K -> increase incentive to own K tf increase in investment (and vice versa)
See notes for diagram
How would an improvement in technology affect investment?
Anything (inc. technology) that increases the marginal product of capital will increase the profitability of investment tf increase investment
Explain the adjustment process? How does it settle in the LR?
If MP(k)>cost of capital, capital accumulates and vice verse. Adjusts until LR eq. at: MP(k)=(P(k)/P)(r+δ) tf change in K=0 and I=δK
What did Tobin’s q seek to find out?
If there is a link between the stock market and investment fluctuations?
What was the ratio Tobin thought firms based investment decisions on?
(Market value of installed capital)/(Replacement cost of installed capital)
What is the market value of installed capital?
number of shares x share prices (STM valuation)
What is the replacement cost of installed capital?
the price of the firms capital stock if purchased today
What will happen if q>1?
– The market values installed capital at more than its replacement cost.
– Managers can therefore increase the value of the firm by acquiring more capital.
– MPK will decline as K↑; continue to accumulate K until q=1.
What will happen if q<1?
– The market values installed capital at less than its replacement cost.
– In this case, managers should reduce the capital stock, or at least not replace capital as it depreciates away.
– MPK will increase as K↓; continue to reduce K until q=1.
How can market value differ from replacement cost? What happens then if MPK is greater or less than the cost of capital?
Since it reflects current AND expected future profitability of firm’s capital stock
-Typically use the stock market to assess the market value of the firm’s capital
If the MPK exceeds the cost of capital then firms are making a profit on their installed capital and these profits feed-through to a higher share price and therefore a higher q.
If the cost of capital exceeds the MPK then firms incur losses on installed capital, which implies a lower share price, which implies a lower q.
What does the data on page 15 tell us?
q ratio often spikes during bubbles
What is the efficient market hypothesis, what does it conclude, and what is the implication of this?
Any fluctuations in share prices are fully rational tf reflects all information that’s relevant and known
Means that only NEW information will change share prices
Share prices should follow and random walk since news is ‘random’ and they only respond to new news
How do fund managers beat the market? (3 options)
information advantage, good luck OR EMH is wrong
See
page 17 keynes beauty contest
Note
What matters in a market is predicting what other investors will value a stock at, not necessarily what it’s actually worth (explains bubbles)
Explain why investment may not go ahead due to financing constraints?
NMoI assumes firms that for firms to proceed with an investment they must only satisfy MPk>capital cost
In reality, banks may be reluctant to lend tf financing constraints tf I decisions may not go ahead (depends on current cash flow rather than future expected profitability)
Explain how the flow of residential investment is determined?
Market for existing stock of houses determines equilibrium price
Equilibrium price determines flow of residential investment undertaken by housing developers
Draw housing market diagram, and supply of new housing diagram?
Now, and explain them (see notes)
What is:
a) P(H)/P
b) K(H)
c) I(H)?
a) relative price of housing
b) stock of housing capital
c) flow of residential investment
What happens if the relative price of housing increases?
It signals to firms to build more houses (relative prices since if cost of production prices rise too, no extra incentive)
What does demand for housing depend on in an owner occupied market?
imputed rent (done by comparing an owner occupied house with a rented house that is similar)
What shifts the housing demand curve?
eg. inc. in population, immigration or decrease in r would all shift D curve outwards
Three facts about inventory adjustment?
– Inventory adjustment is a small component of GDP growth on average, but it contributes a great deal to its volatility.
– Production is more volatile than sales.
– Production and inventory adjustment are pro-cyclical.
Why does inventory adjustment turn negative during recessions?
Firms stop replenishing inventories as goods are sold
3 statistic about inventory adjustments?
On avg, inventory adjustments account for:
- less than 1% nGDP
- 2% of avg. rGDP growth
- 43% of volatility of rGDP growth
4 motivations for holding inventories?
1) Production smoothing
2) Inventories as a factor of production
3) To avoid ‘stock out’
4) Work in progress
Why is production smoothing a motivation for holding inventories and EV?
Firms facing variable demand prefer toi produce goods at a steady rate, tf accumulate inventories when D is low and sell when D is high
Avoids start up costs and shutdown costs
EV: bit outdated, not consistent with data
Why is inventories as a factor of production a motivation for holding inventories?
Holding inventories as a FofP reduces inefficiencies in the production process
Tf larger stock of inventories allows firms to produce more (eg. holding spare parts of machines in case they break)
Why is wanting to avoid ‘stock out’ a motivation for holding inventories?
It prevents the firm running out of goods to sell if D is unexpectedly high
Forecasts have high uncertainty tf ‘buffer stock’ of inventories (don’t want consumers to got to rivals)
Why are WIPs a motivation for holding inventories?
Some industries (eg. shipbuilding) have long productions processes, tf some unfinished goods will be reported in accounts as W.I.P.
Explain why firms may be reluctant to hold inventories?
The real interest rate, r, measures the opportunity cost of tying up money in inventories; these could be sold today and put back in the bank to earn r
tf inc. r -> inc. cost of inventories -> rational firms decrease inventories
note
High r in the 80s -> innovative inventory management systems (see notes)
See
notes credit conditions
