1 Economics 122. Investment Fall 2013 PET Scan of PIB molecule
NOAAs weather supercomputer
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Midterm results Overall: bimodal distribution. Many of you are
apparently engaged in irrational procrastination and suboptimal
study habits: Problem sets Lectures Grade distribution. Roughly
evenly distributed within segments. 2
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3 The Macroeconomics of Investment Capital Produced, durable,
used for further production Examples: tangibles (structures,
equipment) intangibles (software, human capital) Basic role of
investment in macro Short run: most volatile part of aggregate
demand See next slides Long run : key determinant of growth of
potential output and major way that governments affect economic
growth In growth theory
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r = real interest rate Investment (I) I(r) E Why is investment
an inverse function of r?
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5 National accounts include only a small part of
investment-like spending: 12% of 40%. Gross Investment, US, 2010
Counted as investment in National Accounts Sector2010% of GDP GROSS
DOMESTIC PRODUCT15,076 100.0 Total, investment type39.6
Residential/Household1,485 9.9 Durable goods1,146 Residential
structures339 Gross busines domestic investment1,516 10.1 Fixed
investment1,480 Structures405 Equipment and software1,075 Change in
private inventories37 Government gross investment480 3.2 Federal
National defense109 Nondefense52 State and local320 Other
investment-type private spending2,484 16.5 Health1,752 Private
education252 Research and development480
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Investment decline in the Depression 6 Note on data: Very
convenient place is FRED: http://research.stlouisfed.org/fred2
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7 This is only gross domestic private investment. Investment in
the Great Recession
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Todays housing depression 8
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Housing and interest rates with tight money 9
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10 The major theories of investment 1. Neoclassical theory :
Desired capital stock a function of output and cost of capital 2. Q
theory : Investment a function of Tobins Q (Q =ratio of market
value of K to replacement cost)
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11 - L K Cobb-Douglas in neoclassical Production underlying
neoclassical theory
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12 Investment Criteria User cost of capital, uc Central concept
in macro theories of investment Definition. Cost of renting capital
for one period Appropriate for perfect capital market where Q=1*
Estimate as imputed in most circumstances because firms own capital
(also for housing in NIPA) * We will see later that Q = market
value/replacement cost.
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13 Formula for cost of capital uc (1+) p K [r + ] where uc =
user cost of capital p K = price of capital good r = real interest
rate = depreciation rate = effective rate of tax (or subsidy when
negative) on capital goods Linkage to policy: - through real
interest rate - through taxation of capital In practice, uc is
complicated to measure; off to B School!
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14 Derivation and example : Buy a car, rent it for one period,
and then sell at the end. No inflation or taxes. Real interest rate
= r =.05. Pay $20,000 sell for 20,000(1-.1) = $18,000; collect rent
u. What cost of capital (u) would just break even? when p K = p K
(1- )/(1+r) + u 20,000 = 18,000/(1.05) + u uc = 20,000 18,000/1.05
= 20,000 17,143 = 2857 p K (r+ ) = 20,000(.15) = 3,000
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15 This is a slightly more realistic version that has both debt
and equity capital. Cost of capital with no taxes and P = 1
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Derivation of Basic Theory Define the user or rental cost of
capital as uc = (r+) P K as implicit rental on capital. Assume that
Y is given by short-run aggregate demand Cobb-Douglas for
simplicity and p K = p = 1. So the demand for investment is;
proportional to output inverse to the user cost of capital, and
therefore also to the interest rate. 16
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17 -Note that the impact of interest rates on investment is
powerful but depends importantly on the lifetime of the capital:
-Where biggest impacts? Housing. Why? -Where smallest? Computers
and inventories. Why?
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18 From demand for capital to demand for investment Note that
this is the demand for capital out of equilibrium. Generally, go
from demand for capital to demand for investment Several
approaches: -Costs of adjustment of investment (standard in modern
macro) -Capacity in the capital goods industry (Boeing aircraft)
-Construction lags (power plants) -Internal funds constraint
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Now a major puzzle for neoclassical model: housing and interest
rates 19 Tight money ? Housing price crash
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20 The major theories of investment 1. Neoclassical theory :
Desired capital stock a function of output and cost of capital 2. Q
theory : Investment a function of Tobins Q (Q =ratio of market
value of K to replacement cost)
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21 A glut of cargo ships in 2009
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Airplanes in mothballs (Tucson, Arizona) 22
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23 More formally: Q = (market value of K)/(replacement cost of
K) Example: - Cargo ships are selling for a Q of 0.25 - E.g., cost
of production is $20 million, but ships sell for $5 million - How
is this possible? Inelastic supply and high demand for cargo low
rentals PV of ships is low. Therefore, little to no shipbuilding,
and the stock gradually depreciates or is scrapped How does Q
affect investment? - Because Q < 1, shipping firms buy old ships
rather than build new ones - This depresses investment. - Therefore
I/K = f(Q), f(Q) > 0.
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24 3. Q theory of investment Idea here is that investment is
determined by relationship between the value of firms or houses and
the cost of new or replacement capital. Keynes: The daily
revaluations of the Stock Exchange, though they are primarily made
to facilitate transfers of old investments between one individual
and another, inevitably exert a decisive influence on the rate of
current investment. For there is no sense in building up a new
enterprise at a cost greater than that at which a similar existing
enterprise can be purchased; whilst there is an inducement to spend
on a new project what may seem an extravagant sum, if it can be
floated off on the Stock Exchange at an immediate profit. Tobin:
"It is common sense that the incentive to make new capital
investments is high when the securities giving title to their
future earnings can be sold for more than the investments cost,
i.e., when q exceeds one."
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25 Q I/K 1 I/K = f (Q) Investment and Q
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Housing market collapse, 2006 2013+ 26
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27 Housing bubble: 1.Note that Q rose about 50 percent from
mid-1990s. 2. Note huge decline in residential construction (I)
Investment ratio and Q for housing
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Housing Q and housing starts, 2006:m1 2010:m7 28
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29 Summary of investment theory 1. The major components of
investment are residential, business plant and equipment, software,
and inventories. 2. These are among the most volatile components of
output in the short run. 3. In equilibrium, demand for capital
determined where the cost of capital equals the marginal
productivity of capital. 4. The major theories are the the
neoclassical theory and the Q theory. These apply differently in
different sectors. 5. Economic policy affects investment through
both monetary and fiscal policy: monetary policy through real
interest rate and unconventional policies (buying mortgage backed
securities) fiscal policy through things like depreciation policy
and investment tax credits.