1

A SIMPLE MODEL OF INVESTMENT

- Net investment is equal to the change in the capital stock K

1
=
t t t
K K I


- Gross investment includes investment to offset capital
consumption, which depends on the capital stock and rates of
obsolescence.

- Suppose there is a desired capital stock at any moment of
time,
*
t
K

- There are costs involved to adjusting from the existing to the
desired capital stock.

- The firm is only able to invest a portion of what is required to
move to the desired capital stock eg

-
) (
1
*

=
t t t
K K I



- What determines the desired capital stock?


If the production function linking capital and labour is to output,
y=f (K, L) is concave (diminishing returns to capital) , the desired
capital to labour ratio declines as the interest rate rises.

If we assume that the production function has constant returns to
scale we can use the production function in so-called intensive
form.
2

We divide each side of the production function by L and write it as
follows:


) ( ) 1 , ( k f
L
K
F
L
y
= =
where
L
K
k =


The slope of the production function is the marginal product of
capital.

A profit maximizing firm will choose the capital stock such that
the marginal product of capital is equal to the real rate of interest:

MPK= f (k) = r



An increase in interest rate





















k
Y/L
f = (k)
r
A

r
B

*
B
k
*
A
k
B
A
3
An increase in r implies a lower desired capital stock shown by
point B.


Therefore

) (
*
t
t
t
r v
y
K
=
|
|
.
|

\
|



t t t
y r v K ) (
*
=



where v is the capital to output ratio and v(r) <0



If the level of output is not fully known at the time investment
decisions are made, then it is plausible to assume that

E
t t t
y r v K ) (
*
=
where
E
y
is the expected level of output.


Putting the last 2 equations together we have:


) (
1
*

=
t t t
K K I


=
| |
1
) (

t
E
t t
K y r v


This illustrates how investment is a function of the rate of interest
via its role in determining the desired capital stock.


4
We assume that only a portion of the gap between the current and
the desired capital stock can be made up in one period.


Assumptions:

1. Assume that o=1, so that investment fully makes up the
difference between K* and K each period.
2. The capital output ratio is constant, so

= v r v
t
) (


These two assumptions yield:

*
1
*

=
t t t
K K I


=
| |
E
t
E
t
y y v
1

(Accelerator Investment Function)

This is the accelerator relationship: investment in period t is
completely determined by the constant capital output ratio and by
the expected growth in output.






5
Tobins q
numerator: the stock market value of the
economys capital stock.
denominator: the actual cost to replace the capital
goods that were purchased when the stock was
issued.
If q >1, firms buy more capital to raise the
market value of their firms.
If q <1, firms do not replace capital as it wears
out.
Market value of installed capital
Replacement cost of installed capital
q =




























6
Relation between q theory and neoclassical theory described
above
The stock market value of capital depends on the
current & expected future profits of capital.
If MPK >cost of capital, then profit rate is high,
which drives up the stock market value of the firms,
which implies a high value of q.
If MPK <cost of capital, then firms are incurring
losses, so their stock market values fall, so qis low.
Market value of installed capital
Replacement cost of installed capital
q =




The stock market and GDP
Reasons for a relationship between the
stock market and GDP:
1. A wave of pessimism about future
profitability of capital would
cause stock prices to fall
cause Tobins q to fall
shift the investment function down
cause a negative aggregate demand shock



7
The stock market and GDP
Reasons for a relationship between the
stock market and GDP:
2. A fall in stock prices would
reduce household wealth
shift the consumption function down
cause a negative aggregate demand shock


The stock market and GDP
Reasons for a relationship between the
stock market and GDP:
3. A fall in stock prices might reflect bad
news about technological progress and
long-run economic growth.
This implies that aggregate supply and
full-employment output will be
expanding more slowly than people had
expected.



8
The stock market and GDP
Percent
change
from
1 year
earlier
Percent
change
from
1 year
earlier
-30
-20
-10
0
10
20
30
40
50
1970 1975 1980 1985 1990 1995 2000 2005
-6
-4
-2
0
2
4
6
8
10
Stock prices (left scale)
Real GDP (right scale)






The q-theoryof investment
Tobins q
I
n
v
e
s
t
m
e
n
t
0
1