Three types of investment

Business fixed investment:

businesses spending on equipment and
structures for use in production.
Residential investment:
purchases of new housing units
(either by occupants or landlords).
Inventory investment:
the value of the change in inventories
of finished goods, materials and supplies,
and work in progress.
CHAPTER 18 Investment 1
 The cost of capital

Components of the cost of capital:

interest cost: i PK,
where PK = nominal price of capital
depreciation cost: PK,
where = rate of depreciation
capital loss: PK
(a capital gain, PK > 0, reduces cost of K )
The total cost of capital is the sum of these
three parts:
CHAPTER 18 Investment 2
 The cost of capital

Nominal cost PK
i PK PK PK PK i
of capital PK

CHAPTER 18 Investment 3
 The cost of capital

For simplicity, assume PK/PK = .

Then, the nominal cost of capital equals

PK(i + ) = PK(r + )
PK
and the real cost of capital equals r
P
The real cost of capital depends positively on:
the relative price of capital
the real interest rate
the depreciation rate
CHAPTER 18 Investment 4
 The rental firms profit rate

A firms net investment depends on its profit rate:

R PK PK
Profit rate = r = MPK r
P P P
If profit rate > 0,
then increasing K is profitable
If profit rate < 0, then the firm increases profits by
reducing its capital stock
(i.e., not replacing capital as it depreciates)

CHAPTER 18 Investment 5
 Net investment & gross investment

Hence,
net investment = K I n MPK PK P r
where In[ ] is a function that shows how
net investment responds to the incentive to invest.
Total spending on business fixed investment equals
net investment plus replacement of depreciated K:
gross investment K K
I n MPK PK P r K
CHAPTER 18 Investment 6
 The investment function

I I n MPK PK P r K

An increase in r : r
raises the cost
of capital
reduces the r2
profit rate
and reduces r1
investment:
I
I2 I1

CHAPTER 18 Investment 7
 The investment function

I I n MPK PK P r K

An increase in MPK r
or decrease in PK/P
increases the
profit rate
increases
investment at any r1
given interest rate
shifts I curve to I
the right. I1 I2

CHAPTER 18 Investment 8
 Tobins q

Market value of installed capital

q
Replacement cost of installed capital
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.
CHAPTER 18 Investment 9
 Relation between q theory and
neoclassical theory described above
Market value of installed capital
q
Replacement cost of installed capital
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 q is low.

CHAPTER 18 Investment 10
 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

CHAPTER 18 Investment 11
 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

CHAPTER 18 Investment 12
 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.

CHAPTER 18 Investment 13
 Alternative views of the stock market:
The Efficient Markets Hypothesis
Efficient Markets Hypothesis (EMH):
The market price of a companys stock is the fully
rational valuation of the company,
given current information about the companys
business prospects.
Stock market is informationally efficient:
each stock price reflects all available information
about the stock.
Implies that stock prices should follow a random
walk (be unpredictable), and should only change
as new information arrives.
CHAPTER 18 Investment 14
 Alternative views of the stock market:
Keyness beauty contest

Idea based on newspaper beauty contest in which

a reader wins a prize if he/she picks the women
most frequently selected by other readers as
most beautiful.
Keynes proposed that stock prices reflect peoples
views about what other people think will happen to
stock prices; the best investors could outguess
mass psychology.
Keynes believed stock prices reflect irrational
waves of pessimism/optimism (animal spirits).

CHAPTER 18 Investment 15
 Alternative views of the stock market:
EMH vs. Keyness beauty contest
Both views persist.
There is evidence for the EMH and random-walk
theory (see p.498).
Yet, some stock market movements do not
seem to rationally reflect new information.

CHAPTER 18 Investment 16
 Financing constraints
Neoclassical theory assumes firms can borrow to
buy capital whenever doing so is profitable.
But some firms face financing constraints:
limits on the amounts they can borrow
(or otherwise raise in financial markets).
A recession reduces current profits.
If future profits expected to be high,
investment might be worthwhile.
But if firm faces financing constraints and current
profits are low, firm might be unable to obtain funds.

CHAPTER 18 Investment 17
CHAPTER 18 Investment 18
 Residential investment
The flow of new residential investment, IH ,
depends on the relative price of housing PH /P.

PH /P determined by supply and demand in the

market for existing houses.

CHAPTER 18 Investment 19
 How residential investment is
determined
(a) The market for housing
PH
Suppl Supply
Supply and
and demand
demand for
for
P y houses
houses determines
determines the
the
equilib.
equilib. price
price of
of houses.
houses.

The
The equilibrium
equilibrium price
price of
of
houses
houses then
then determines
determines
residential
residential investment:
investment:
Demand
KH
Stock of
housing capital
CHAPTER 18 Investment 20
 How residential investment is
determined
(a) The market for housing (b) The supply of new housing
PH PH
Suppl
P y P
Suppl
y

Demand
KH IH
Stock of Flow of residential
housing capital investment
CHAPTER 18 Investment 21
 How residential investment responds
to a fall in interest rates
(a) The market for housing (b) The supply of new housing
PH PH
Suppl
P y P
Suppl
y

Demand
KH IH
Stock of Flow of residential
housing capital investment
CHAPTER 18 Investment 22
 Stylized facts:
Housing constitutes a significant share
of household expenditure as well as
total wealth.
Usually, the value of the residential
Why is capital stock is larger than that for
business capital, and usually, the
Housing annual market value of residential
investment is larger than that for
market business capital investment
importan Significant fluctuations in housing price
would imply significant fluctuations in
t? wealth, and thus potentially significant
household wealth effects. housing is
not just another consumption good.
The market value of the US residential
property stock is approximately equal
to the annual average GDP.
Linkages Inflation

Fiscal Consumptio
n
Housi
ng
Prices

Investme
Banking
nt
 The typical residential housing transaction is
financed largely with borrowed money.
The use of such leverage to purchase an asset
magnifies the risk assumed by the buyer.
If the value of the asset subsequently drops, as in
a burst bubble, the debt incurred to buy the asset
remains in place
The buyer must still repay the loan in full. If the
debt exceeds the assets market value, refinancing
options are limited.
If the debt is very large relative to the buyers
income, repayment can strain the buyers
finances, forcing a reduction in other spending.
And if the strain becomes too great, the buyer
may be forced to default, shifting some or all of
the loss to the lender or the taxpayer if the loan is
government insured.
 A link between credit and house prices
may arise via housing wealth and
collateral effects on credit demand and
credit supply and via repercussions of
credit supply fluctuations on house prices.
A permanent increase in housing wealth
leads to an increase in household
spending and borrowing when
homeowners try to smooth consumption
over the life cycle.
There is also a collateral effect of house
prices emanating from the fact that
houses are commonly used as collateral
for loans
.As a consequence, higher house prices
induce homeowners to spend and borrow
more.
 The most direct effect of house price
fluctuations on economic activity is via
residential investment. An increase in
house prices raises the value of
housing relative to construction costs,
GDP Employment

20 13
% %

Construction Construction
(8.2%) (11.3%)
Real Estate Real Estate
Drivers of Real Estate
Sector
 PropTiger Charts
Singapore's per capita income is the highest in Asia, but home
prices are only moderately higher than that of India's
 In India, the ratio of home prices to income is high while gross rental yield is low.
 Motives for holding inventories

1. production smoothing
Sales fluctuate, but many firms find it cheaper to
produce at a steady rate.
When sales < production, inventories rise.
When sales > production, inventories fall.

CHAPTER 18 Investment 34
 Motives for holding inventories

1. production smoothing
2. inventories as a factor of production
Inventories allow some firms to operate more
efficiently.
samples for retail sales purposes
spare parts for when machines break down

CHAPTER 18 Investment 35
 Motives for holding inventories

1. production smoothing
2. inventories as a factor of production
3. stock-out avoidance
To prevent lost sales when demand is higher
than expected.

CHAPTER 18 Investment 36
 Motives for holding inventories

1. production smoothing
2. inventories as a factor of production
3. stock-out avoidance
4. work in process
Goods not yet completed are counted in
inventory.

CHAPTER 18 Investment 37
 Inventories, the real interest rate,
and credit conditions
Inventories and the real interest rate
The real interest rate is the opportunity cost of
holding inventory (instead of, e.g., bonds)
Example: High interest rates in the 1980s
motivated many firms to adopt just-in-time
production, which is designed to reduce
inventories.
Inventories and credit conditions
Many firms purchase inventories using credit.
Example: The credit crunch of 2008-09 helped
cause a huge drop in inventory investment..
CHAPTER 18 Investment 38
 Assume that there is a stable relationship
between the total capital stock, K, and
total GDP, Y.
Now suppose that this ratio, known as the
capital-output ratio, is defined as k.
Assume that the national saving ratio, s,
is a fixed proportion of national output.
Assume that total new investment is
determined by the level of total savings.
 Savings, S, is some proportion, s, of
national income, Y, such that S = s
(Y)
Investment, I, is defined as the
change in capital stock, K, such that
I = K
K = kY K = k (Y) I = k (Y)
Since total national saving, S, must
equal total investment, I, then S =
k (Y)
Dividing both sides by Y we get
s/k = Y/Y
The rate of growth of GDP (Y/Y) is
determined jointly by the national
saving ratio (usually expressed as a
percentage), s, and the national
capital-output ratio (expressed as an
integer), k.
 k is the ICOR or incremental capital
output ratio
Defined as the inverse of the
marginal productivity of capital.
Assume that the national capital-
output ratio of a country is 3 and that
the aggregate savings ratio is 6% of
GDP, then it follows that this country
can grow at a rate of 2% per year.
 capital-output ratio = 3
desired % growth in GDP = 5%
Investment (as % of GDP) required to
achieve this growth = 15%
I (as % GDP) required (15%) S (12%) =
3% of I required from external sources
Target growth rate times ICOR gives
investment requirements