Week 9

Question 1

Consumption as a random walk

Answer 1

Changes in consumption should be unpredictable.

Expected changes are already taken into account in our choice of current consumption/

Question 2

Precautionary saving + what about consumers with sufficient wealth?

Answer 2

Consumers w/ less wealth save money in case of an unpredictable event. Behave as if they face a borrowing constraint.

Consumers with sufficient wealth base consumption decisions over the PDV of their lifetime wealth - PERMANENT-INCOME hypothesis

Question 3

Arbitrage equation - Investment
How much capital to invest in?
2 effects of increasing taxes

Answer 3

Invest in capital until MPK = r - Δpk/pk, ie. until MPK = difference between real interest rate & the growth rate of the price of capital (capital gain)

If including depreciation, MPK = r + d - Δpk/pk

If including tax, MPK = (r + d - Δpk/pk) / 1 - tax

1. Increase taxes, increase USER COST OF CAPITAL duties
2. Optimal K becomes smaller

Question 4

MPK vs User cost of capital

Answer 4

MPK = (r + d - Δpk/pk) / 1 - tax

MPK is the BENEFIT/extra output from having 1 additional unit of capital.
User cost of capital is the COST of having 1 additional unit of capital.

Question 5

Relating to the production function, MPK = …?

Answer 5

MPK = 1/3 Y/K

*1/3 depends on value of parameter alpha

Question 6

Investment rate formula + depends on 3 terms

Answer 6

It/Yt = (gK + d)/(3 uc)

Increases with...
1. gK, desired growth rate of capital stock
2. d, depreciation rate
Decreases with...
3. uc, user cost of capital

Question 7

Arbitrage equation - Price of a stock / Fundamental value of a stock

Answer 7

ps = dividend / (r - Δps/ps)
ps = dividend / (interest rate - capital gain)

*will = the PDV of the dividends the stock will pay

Question 8

Price-earnings (P/E) ratio

Answer 8

ps/earnings = (dividend/earnings ) / (interest rate - capital gain)

The higher the P/E ratio, the more discrepancy between the fundamental value & the price the stock is trading at. Suggests a bubble (b/c not possible to be so high).

Question 9

Informationally efficient market

Answer 9

Only unexpected info that arrives can change the price of stocks in the financial markets, ie. stock prices follow a RANDOM WALK

Financial prices should reflect completely all the available info. Thus impossible to make profits by trading on basis of information

Question 10

Tobin’s q formula + 2 basic predictions

Model: A firm’s only asset is capital. Stock value of firm is the value of its capital stock.

Answer 10

q = V/ (pk*K)
q = stock market value / value of capital 

If q > 1, firm is OVERvalued & should invest in more capital.
- firms may see increased competition
If q < 1, firm is UNDERvalued & should disinvest

2 basic predictions:

1. Value of q should be close to 1
2. Value of q should be a useful predictor of firm investment

Question 11

3 main components of investment

Answer 11

1. 2/3 nonresidential fixed investment
   - equipment and structures purchased by businesses + intellectual property products
2. Residential fixed investment
   - buying new housing by households
3. Inventory investment
   - goods produced by households but not sold

Question 12

3 motives to hold inventory

Answer 12

1. Production smoothing
   - costly to increase production in times of high demand
2. Pipeline theory
   - firms hold inventory as part of production process itself
3. Stockout avoidance
   - hold inventories of final goods to ensure availability if a customer wants to make a purchase