Lecture IV Investment

1
Lecture IVInvestment
2
Volatile component of aggregate demand

• OECD countries investment share on GDP 15 25
• Countries with fast economic growth up to 40 GDP
• Quickly reflect economic cycle
• Closely linked to the situation of financial
  markets and equity markets

3
(No Transcript)
4
Classification of investment

• Now, fixed investment only
• Business fixed investment of corporations
• Residential (households) investment (namely real
  estate)
• Inventory investment
• Lecture II above conclusions for investment
• Determined by real interest
• Interest determined on market with loanable funds
• Lexture IV - more detailed analysis

5
IV.1 Business fixed investment
6
Optimization by the firm (Lecture II)

• Standard firm
• Usual production function, real rental costs of
  unit of capital R/P
• Real contribution, when using additional unit of
  capital MPK
• Profit maximization additional units of capital
  added up to the point when MPKR/P
• Profit max ? P.F(K,N) W.N R.K
• First order conditions FNW/P, FKR/P

7
What determines investment decisions?

• Each unit of capital used generates return for
  the firm, but costs at the same time
• Return R/P imagine that it is a price, that a
  firm must pay when renting capital form
  specialized company
• Costs what must paid for investment
• Both explicit and implicit costs

8
Return and rental price of capital (1)

• R/P
• Determined on market with capital, where demand
  is given by MPK and supply is fixed
• Example Cobb-Douglas production function
• At point when profit max
  

9
R/P
supply of capital
MPK
K
10
Return and rental price of capital (2)

• Impact on return (and rental price)
• The lower is the capital stock, the higher is its
  rental price
• The higher is the utilization of capital, he
  higher is its rental price
• The better is the technology, the higher is its
  rental price

11
Costs of capital (1)

• Financing of capital purchase unit price
  and nominal interest i, then financing costs are
• Changes of price of capital during its
  utilization
• Depreciation, rate , depreciation from a unit
  of capital

12
Costs of capital (2)

• Total costs of capital
• Suppose that
• where is inflation rate then is
  real interest r
• Total costs of capital

13
Investment by firms (1)

• Investment decision comparison of return and
  costs, i.e. considering the difference
• Gross investments (by firms) are then a function
  of the last expression just above plus the
  depreciation

14
Investment by firms (2)

• When prices (R,P) a and depreciation rate is
  given, then investment depends on interest r,
  indeed
• A decrease of r increases the return and increase
  amount of investment as well and vice versa
• Each fact, changing MPK (e.g. technical progress)
  shifts the investment function

15
Adjustment over time

• Investment either increases or decrease amount of
  capital, thus changing MPK
• Starting when MPK is higher than capital costs,
  then by investing, amount of capital increases
  and MPK decreases starting when MPK is smaller
  than capital costs, then no investment, amount of
  capital decreases (through depreciation, but
  also, e.g., production units are being closed)
  and MPK increases
• Equilibrium

16
IV.2. Stock market and Tobin's q

• In reality ownership of all companies mainly
  through shareholding, with shares publicly
  traded on stock markets
• Principle rationale of shares source of
  financing for any firms activity (not only
  source of capital)
• Share price market value of firms capital at
  given moment, without almost any relation to
  original price, as it reflects market opinion
  about current (financial) situation of the firm
  and outlook into the future

17
Share price as a signal

• High share price reflects an estimate of
  future returns of the firm, or - rather -
  discounted value of companys income in the
  future
• The higher is this discounted value, the higher
  is the profitability and, consequently, higher
  willingness to invest

18
Tobin's q

• Investors decide according following ratio
• q gt 1 share market values capital higher than
  are the replacement costs ? by investing, market
  value of the firm increases
• q lt 1 vice-versa

q
market value of installed capital
replacement cost of installed capital
19
James Tobin

• 1918 2002
• Yale University
• Essential contribution to the development of
  keynesianism
• Nobel price in 1981

20
(No Transcript)
21
Tobin's q and MPK

• If MPK higher than reproduction costs of capital,
  than by using capital, firm generate profit ?
  share prices of profitable company tend to
  increase, nominator in q increases
• Denominator in q (replacement costs) much more
  stable ? q gt 1
• When MPK lower than replacement costs, firms are
  not profitable, market value of shares decreases,
  q lt 1

22
Tobins q and real interest

• Market valuation of shares, based on future
  discounted returns
• Decrease of r ? increase of PVR, hence higher
  market value of shares ? higher q ? higher
  investment
• But again investment as decreasing function of
  real interest

23
IV.3 Household (residential) investment

• In general also consumer durables (cars, etc.),
  but mainly residential investments (houses)
• Closely linked to real estate market and
  mortgages
• We distinguish 2 types of investment
• Market with existing houses, etc.
• Investment into new residential construction

24
Existing residential market

• Price at this market differs from general price
  level on market with goods,
• Houses, flats - normal good demand is decreasing
  function of relative price
• Supply of houses and flats (attention, this
  amounts to supply of capital in this case!) is
  fixed
• Price determined by demand and supply on the
  market
• Prices on real estate market - quite flexible in
  todays world (as we have just witnessed)

25
New residential investment

• Supply (new residential construction) again
  depends on relative prices
• Supply is increasing function of price
• However, price is given on the market with
  existing residential assets
• This price then determines an amount of new
  investment by households
• Link to Tobin's q

26
supply of households investment
S
D
existing residential assets
household investment
27
Changes in demand for residential investment

• (i.e. changes in demand for residential assets)
• Demand curve shifts because of external effects
  booms or recessions, migration waves,
  increase/fall of birth rates, etc.
• Shifts because of interest changes indirect
  impact, most of household is financing investment
  using mortgages, lower interest ? more affordable
  mortgages ? shift (increase) of demand
• Change in interest influences new investments as
  well

28
IV.4 Inventory investment

• Negligible share on total aggregate demand
  (approx. 1)
• However, very volatile, very important for
  economic cycle
• Different reasons for inventory build-up time
  difference between production and sales,
  efficiency of sales, prevention against
  uncertainty, sometimes directly given by the
  nature of production (technology)

29
A simple model

• Inventories proportional to product, i.e. given
  by expression
• Change in inventories (i.e. inventory investment,
  is proportional to change in product
• Link to interest higher interest ? higher cost
  for inventory maintenance (opportunity costs) ?
  lower inventory investments

30
IV.5 Summary

• 3 types of investments discussed in detail
  investic
• Total investment
• All 3 components are decreasing function of real
  interest rate , i.e. indeed

31
Literature to LIV

• Mankiw, Chapter 17
• Holman, Chapter 4, pp. 51-57