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Business, Government, and the World Economy Investment and Saving 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 Increase in Consumption

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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


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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.


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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 IRR>WACC)

  • 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 < uc the firm 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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Tobin’s 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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Tobin’s q

  • The rate of investment depnds upon the ratio of the capital’s 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 firm’s 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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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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S&P 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

Kt+1 = Capital stock end of the year

d = depreciation

Net invest = Gross Invest – depreciation

Kt+1-Kt= It – dKt

Gross Invest = Net Invest + Depreciation

It = Kt+1-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 Individual’s 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*

* Abel and Bernanke MAcroeconomics


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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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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


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