business government and the world economy l.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Business, Government, and the World Economy PowerPoint Presentation
Download Presentation
Business, Government, and the World Economy

Loading in 2 Seconds...

play fullscreen
1 / 45

Business, Government, and the World Economy - PowerPoint PPT Presentation


  • 452 Views
  • Uploaded on

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

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Business, Government, and the World Economy' - emily


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
aggregate demand
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
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.
volatility of investment
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.
lags and investment
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
desired capital stock
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
finance 101
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.
marginal product of capital
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.
marginal product of capital10
Marginal Product of Capital

Expected Future Marginal Product of Capital

Capital Stock

user cost of capital
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)
marginal product of capital12
Marginal Product of Capital

A

Expected Future Marginal Product of Capital

User Cost of Capital

B

Capital Stock

desired capital stock13
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.
changes in desired capital stock
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
increased mpk f causes increased desired capital stock
Increased MPKf causes Increased Desired Capital Stock

Expected Future Marginal Product of Capital

A

B

User Cost of Capital

Capital Stock

tobin s q
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.
tobin s q17
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)
q and when to invest
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
q and fin 101 irr wacc
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)
q and fin 101 irr wacc20
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
determinants of q
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
s p 500 and investment
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
desired capital stock and investment
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

replace k with desired capital stock k
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

goods market equilibrium
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
y c d i d g
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

desired saving and desired investment
Desired Saving and Desired Investment
  • Starting with Y = Cd + Id + G and rearranging you get

Y - Cd –G = Id

Or

Desired Saving = Desired Investment

goods market equilibrium30
Goods Market Equilibrium
  • The real interest rate will move the goods market toward equilibrium
saving decisions
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)
graphing the saving supply of funds function
Graphing the Saving (Supply of Funds) Function

S

Real

Interest

Rates

Level of

Saving

saving decisions33
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.
graphing the saving supply of funds function34
Graphing the Saving (Supply of Funds) Function

An increase in the level of wealth

S0

S1

Real

Interest

Rates

Level of

Saving

saving decisions summary
Saving Decisions Summary*

* Abel and Bernanke MAcroeconomics

investment decisions
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.
graphing the investment demand for funds function
Graphing the Investment (Demand for Funds) Function

Real

Interest

Rates

I

Saving / Investment

slide39
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
graphing the investment demand for funds function40
Graphing the Investment (Demand for Funds) Function

An increase in the Marginal Productivity of Capital

Real

Interest

Rates

D1

D0

Saving / Investment

equilibrium
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.
graphing the saving supply of funds function42
Graphing the Saving (Supply of Funds) Function

Real

Interest

Rate

S

r

I

Level of

Saving /Investment

SI

changes in equilibrium
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.
slide44
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)
measuring investment
Measuring Investment
  • NIPA tables
  • Economic Indicators
    • Factory Orders
    • Business Inventories
    • Capacity Utilization and Industrial Production