Business, Government, and the World Economy

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Business, Government, and the World Economy

• Investment and Saving

2
Aggregate Demand

• The amount that consumers, business and
  Government wants to purchase.
• Consumption
• Investment
• Government
• IS/LM Model joint determination of output and
  interest rates

3
Increase in Consumption

• An increase in consumption may not increase
  aggregate demand if consumers substitute
  consumption for saving.
• A decrease in saving decreases business
  investment.

4
Volatility of Investment

• Investment is more volatile than output.
• Investment tends to cluster in certain years, but
  can have a long term impact.
• Cooper, Haltwinger, and Power AER 1999 Sample
  of firms - 17 of investment over a 20 year span
  takes place in the heaviest year, next heaviest
  year less than 12.
• Investment tends to correspond with peak spending
  years.

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Lags and Investment

• It makes sense that investment is more volatile.
  
• There are time lags with investment it takes
  time to build new plants and equipment

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Investment and GDPQuarterly Change
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Desired Capital Stock

• The desired capital stock is the equilibrium
  level of capital spending (it maximizes profit
  for firms).
• The level of the capital stock is determined in
  part by the marginal product of capital The
  additional benefit of adding one more unit of
  capital.
• However there is a lag in the investment in
  capital and its impact on productivity so we
  are actually looking at the expected future
  Marginal Product of Capital

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Finance 101

• When will a firm invest in new capital?
• When the marginal product of capital exceeds the
  user cost of capital (think IRRWACC)
• The same type of principles apply here.

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Marginal Product of Capital

• As the capital stock increases each unit has a
  lower benefit. In other words there are
  diminishing marginal productivity of capital.

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Marginal Product of Capital
Expected Future Marginal Product of Capital
Capital Stock
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User Cost of Capital

• The user cost of capital is the cost of using a
  unit of capital for a specified period of time
• Interest cost (the real interest rate x price of
  capital goods)
• Depreciation costs (the depreciation rate x the
  price of capital goods)

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Marginal Product of Capital
A
Expected Future Marginal Product of Capital
User Cost of Capital
B
Capital Stock
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Desired Capital Stock

• At A in the previous slide MPKf uc it makes
  sense for the firm to add to its capital stock
• At B in the previous slide MPKf should decrease its desired capital stock
• The tax rate also impacts the relationship The
  after tax MPK should be compared to the after tax
  uc.

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Changes in Desired Capital Stock

• The equilibrium level of capital stock will
  change based on
• Price of capital
• Real rate of interest
• Marginal productivity of capital

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Increased MPKf causes Increased Desired Capital
Stock
Expected Future Marginal Product of Capital
A
B
User Cost of Capital
Capital Stock
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Tobins q

• The value of the stock market plays a role in
  consumers willingness to spend and save.
• Similarly changes in the value of the stock
  market may impact the desire of a firm to invest
  (a wealth effect).
• Therefore an increase in the value of the firm
  should cause an increase in the desire to invest.

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Tobins q

• The rate of investment depnds upon the ratio of
  the capitals market value (V) to its replacement
  cost (Price of capital x capital stock)

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q and when to Invest

• If q is greater than one, it implies that the
  market is placing a higher value on the firms
  assets than the cost of replacing the assets
  the firm should invest
• If q is less than one the market is valuing the
  firms assets at a price less than the cost of
  replacing the assets the firms should start
  selling off assets

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q and Fin 101 (IRR WACC)

• The return on investment can be measured by the
  return on investment in new capital (basically
  the ROC)
• The required rate of return to shareholders can
  provide a measure of the cost investing (ROE)

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q and Fin 101 (IRR WACC)

• The ratio of the return on investing to the cost
  should be greater than 1 (the return above the
  cost) for the firm to invest

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q and Fin 101 (IRR WACC)
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Determinants of q

• The same three factors in the original model
  impact q
• If MPKf increases future earnings increase
  causing Firm Value to increase and q
• If the real rate of interest decreases
  consumers substitute low yielding investment for
  higher yielding investments increasing value
  and q
• A decrease in purchase price of capital increases
  q

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Stock Prices and Investment
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SP 500 and Investment

• The aggregate data does not show a strong link
  between stock prices and investment.
• Implications / Reasons
• Firms do not find short term shifts in stock
  market values to be informative OR
• Firms concentrate too much on the short term
• Intangible assts are also part of investment but
  are not measured well.
• Internal funds are major source of financing
  current cash flow (not future productivity) has
  an impact

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Desired Capital Stock and Investment

• It Gross investment in goods and services
• Kt Capital Stock at the beginning of the year
• Kt1 Capital stock end of the year
• d depreciation
• Net invest Gross Invest depreciation
• Kt1-Kt It dKt
• Gross Invest Net Invest Depreciation
• It Kt1-Kt dKt

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Replace K with Desired Capital Stock K

• It K-Kt dKt

Desired Net Increase in Capital Stock Real
Interest Rate Future Marginal Productivity of
Capital Purchase price of Capital Tax Rates
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Goods Market Equilibrium

• Last Class we stated that in a closed economy (no
  trade) in other words that income and spending
  were always equal
• Y C I G
• Let Y be the quantity of goods and services
  supplied by firms
• Now on the RHS Substitute desired consumption and
  desired investment (Cd Id) for C and I

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Y Cd Id G

• Y Quantity of goods supplied
• Cd Id G quantity of goods demanded
• Unlike the GDP equation on the previous slide
  this will not always be in equilibrium
• For example, If firms produce too much output,
  inventories increase I this case production
  exceeds desired spending. The market will react
  to bring the goods market back to equilibrium

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Desired Saving and Desired Investment

• Starting with Y Cd Id G and rearranging you
  get
• Y - Cd G Id
• Or
• Desired Saving Desired Investment

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Goods Market Equilibrium

• The real interest rate will move the goods market
  toward equilibrium

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Saving Decisions

• Keeping everything else constant, if individuals
  are rewarded with a higher return on their
  investment, they will save more.
• This implies a direct relationship between saving
  and the quantity of dollars supplied (As r
  increases s increases)

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Graphing the Saving (Supply of Funds) Function
S
Real Interest Rates
Level of Saving
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Saving Decisions

• Last class we how a consumer decided to spend
  (consume or save)
• Saving Decision - An Individuals decision to
  save or consume at a given level of interest
  rates will depend upon two main things
• Marginal Rate of Time Preference
• Trading current consumption for future
  consumption
• Income and wealth effects
• Generally higher income save more
• A change in these variable will cause the level
  of saving at each level of interest rates to
  change.

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Graphing the Saving (Supply of Funds) Function
An increase in the level of wealth
S0
S1
Real Interest Rates
Level of Saving
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Saving Decisions Summary
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Investment Decisions

• The reward for saving comes from business being
  willing to pay interest for the funds they
  borrow.
• Keeping everything else constant, if business is
  required to pay a higher level of interest rates
  on its borrowing, it will borrow (and invest)
  less.
• This implies an inverse relationship between the
  demand for funds by business and the level of
  interest rates.

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Graphing the Investment (Demand for Funds)
Function
Real Interest Rates
I
Saving / Investment
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Determinants of Investment
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Note

• The availability of credit plays a role in both
  consumption and investment (the yield spread can
  serve as an indicator for this)
• In part reflected by expected future real
  interest rates
• Increased borrowing may increase the user cost of
  capital, even if the market rate does not change
• IPOs and venture capital play a key role in small
  firms access to funds

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Graphing the Investment (Demand for Funds)
Function
An increase in the Marginal Productivity of
Capital
Real Interest Rates
D1
D0
Saving / Investment
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Equilibrium

• The level of interest rates will then be
  determined by the intersection of the saving
  (supply of funds) and investment (demand for
  funds) functions.
• At this intersection the demand for funds equals
  the supply of funds. If demand does not equal
  supply, the level of interest rates will adjust.

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Graphing the Saving (Supply of Funds) Function
Real Interest Rate
S
r
I
Level of Saving /Investment
SI
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Changes in Equilibrium

• A change in the economy that causes a shift in
  either the saving or investment function will
  cause a change in the general level of interest
  rates.
• For example What if new technology increases
  the productivity of capital?
• The demand for funds will be higher at each level
  of interest rates. At the original r, Investment
  Savings so real interest rates will increase as
  firms compete to attract funds.

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Note

• So far we have not included international trade.
  The equilibrium will be impacted by foreign
  savers and the ability for Domestic consumers to
  save abroad. (we will cover this soon)

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Measuring Investment

• NIPA tables
• Economic Indicators
• Factory Orders
• Business Inventories
• Capacity Utilization and Industrial Production