Chapter 4

Investment and Stock Market

- Stock price times number of shares equals firm's market value, which equals value of firm's capital • Formula: q = V/(pKK), where V is stock market value of firm, K is firm's capital, pK is price of new capital • So pKK is the replacement cost of firm's capital stock • Stock market boom raises V, causing q to rise, increasing investment Higher MPKf increases future earnings of firm, so V rises • A falling real interest rate also raises V as people buy stocks instead of bonds • A decrease in the cost of capital, pK, raises q

inventory investment

= the increase in firms inventories of unsold goods, unfinished goods, or raw materials.

income effect of the real interest rate on saving

reflects the change in current consumption that results when a higher real interest rate makes a consumer richer or poorer

substitution effect of the real interest rate on saving

reflects the tendency to reduce current consumption and increase future consumption as the price of current consumption, 1+r, increases.

tax-adjusted user cost of capital

shows how large the before-tax future marginal product of capital must be for a firm to willingly add another unit of capital -an increase in the tax rate t raises the tax-adjusted user cost and thus reduces the desired stock of capital MPKf= (uc)/(1-t) = (r+d)pk/(1-t)

downward

the MPKf curve slopes xxxx because the marginal product of capital falls as the capital stock is increased

depreciation rate and the initial capital stock

the amount of depreciation that is done in a year is determined by the xxxx

the marginal product of capital, MPK

the benefit to a firm of having an additional unit of capital is

gross investment

the capital stock (of a firm or a country) changes over time through 2 opposing channels. 1) we've been calling the total purchase or construction of new capital goods that take place each year "investment," but its precise name is xxxxx. 2) the capital stock depreciates or wears out, which reduces capital stock

consumption smoothing motive

the desire to have a relatively even pattern of consumption over time - avoiding periods of very high or very low consumption.

marginal propensity to consume MPC

the fraction of additional current income that she consumes in the current period - will be between 0 and 1

Ricardian equivalence proposition

the idea that tax cuts do not affect desired consumption and (therefore) also do not affect desired national saving. -believe that although they're having a tax cut today, they're just going to have to pay more later so theres no reason to respond to the tax cut by change their desired consumption

effect of fiscal policy, a current tax cut

thus in principle, xxxx - which raises current incomes bit lowers expected future incomes - could either raise or lower current desired consumption

increase

to summarize, an xxxxx in an individuals expected future income is likely to lead that person to increase current consumption and decrease current saving. the same result applies at the macroeconomic level: If people expect that aggregate output and income, Y, will be xxxxmi fr in the future, current desired consumption Cd should increase and current desired national saving Sd should decrease.

increases, reduces

wealth xxxx current consumption and xxxx current saving

depreciation allowances

when a firm purchases some capital, it is allowed to deduct part of the purchase price of the capital from its taxable profit in both the year of purchase and in subsequent years. by reducing the amount of profit to be taxed, these deductions, known as xxxxx, allow the firm to reduce its total tax payment.

net investment

whether capital stock increases or decreases over the course of a year depends on whether gross investment is greater than or less than depreciation during the year. the change in capital stock over the year, or equivalently, the difference between gross investment and depreciation is xxxxx =Kt+1 - Kt

real interest rate r

xxxx determines the relative price of current consumption and future consumption

real interest rate

xxxxxx is the key economic variable whose adjustments help bring the quantities of good supplied and demanded into balance

Tobins q theory of investment

In touch with data and research: investment and the stock market - Firms change investment in the same direction as the stock market: xxxxx - If market value > replacement cost, then firm should invest more - xxxx = capital's market value divided by its replacement cost • If q < 1, don't invest • If q > 1, invest more

shows that any factor that leads to a change in the desired capital stock K* results in an equal change in gross investment

It = K* - Kt + dKt shows the firms gross investment during a year has 2 parts: 1) the desired net increase in the capital stock over the year K* - Kt and 2) the investment needed to replace work out or depreciated capita, dKt.

relationship between desired capital stock and investment

It = Kt+1 -Kt + dKt gross investment = net investment + depreciation

Relationship between net and gross investment

Kt+1 - Kt = It - dKt net investment = gross investment - depreciation

another form of goods market equilibrium theory

Sd = Id or Y - Cd - D = Id, says that goods are in equilibrium when desired saving = desired investment

stock market

Sharp changes in xxx affect consumption spending (a wealth effect) and capital investment (via Tobin's q)

increase, reduce

Thus for a saver who is a recipient of interest payments, the income effect of an increase the real interest rate is to xxxx current consumption and xxxxx current saving. -therefore for a saver, the income and substitution effect of an xxx in the real interest rate work in opposite directions, with the income effect xxx saving and the substitution effect xxxx saving.

increases

a decrease in the expected real interest rate (or any other change that lowers the uc) xxxx the desired capital stock

expected after tax real interest rate

a useful measure of the returns received by savers that recognizes the affects of taxes. its the after tax nominal interest rate minus the expected inflation rate ra-t=(1-t)i-pie -appropriate interest rate for consumers to use in making consumption and saving decisions because it measures the increase in the purchasing power of their saving after payment of taxes.

national level of desired consumption

aggregate quantity of goods and services that households want to consume, given income and other factors that determine households economic opportunities

desired capital stock

amount of capital that allows the firm to earn the largest expected profit -xx at which the expected future marginal product of capital = uc

increases

an increase in the real interest rate xxx the amount of interest payments that a borrower must make, thereby making the borrower unable to afford the same levels of current and future consumption as before the xxxx in the real interest rate. -borrower suffers loss of wealth -hence for a borrower, the income effect of an increase in the real interest rate is to increase saving. thus both the substitution effect and the income effect of an increase in the real interest rate increase the saving of a borrower.

firms desired capital stock

any factor that shifts the MPKf curve or changes the user cost of capital changes the xxxxx -including technological changes

low

because an increase in the effective tax rate on capital increases the tax-adjusted user cost of capital, we would expect countries with her effective tax rates on capita to have xxxx rates of investment, all else being equal.

high rate

because investment creates new capital goods, a xxx of investment means that capital stock is growing quickly.

expected future marginal product of capital, MPKf

benefit from increasing investment today by one unit of capital. -this expected future benefit must be compared to the expected cost of using that extra unit of capital (user cost of capital)

residential investment

construction of housing, such as a single family home, condo, or apartment building

effective tax rate

economists summarize the many provisions of the tax code affecting investment by a single measure of the tax burden on capital called xxxx. -all else being equal, an increase in xxxxx lowers the desired capital stock.

user cost of capital (uc)

expected real cost of using a unit of capital for a specific period of time -sum of the depreciation cost (dpk) and the interest cost (rpk) (pk=real price of capital goods) =rpk+dpk = (r+d)pk

Cd

fiscal policy affects xxxxx, primarily by affecting households current incomes and expected future incomes

right, left

for any real interest rate, a change in the economy that raises desired investment shifts the investment curve to the xxxx, and a change that lowers desired investment shifts to the xxxxx.

right, left

for any real interest rate, a change in the economy that raises desired saving sifts the saving curve to the xxxxxx and a change that reduces national desired saving shifts the curving to the xxxxx.

Y = Cd + Id + G goods supplied by firms = goods demanded

goods market is in equilibrium when aggregate quantity of goods supplied = aggregate quantity of goods demanded -equation is called goods market equilibrium condition (does not always have to be satisfied)

positive, increases

gross investment > depreciation, net investment is xxxx and capital stock xxxxx

crowded out (left shift in S)

in response to the increase in government purchases, national saving and investment both fall. saving falls because of the initial decrease in desired saving, which is only partially offset by the increase in the real interest rate. investment falls because the higher real interest rate raises the uc that firms face. when increased government purchases cause investment to decline, economists say that investment has been xxxxx. the xxxx of investment by increased government purchases occurs, in effect, because the government is using more real resources, some of which would otherwise have gone into investment.

downward

in the goods market equilibrium, the investment curve slopes xxx because a higher real interest rate increases the user cost of capital and thus reduces desired investment

upward

in the goods market equilibrium, the saving curve slopes xxx because the higher real interest rate rates desired national saving

2 examples of fiscal policy

increase in government purchases, a tax cut

taxed

interest earnings (and other returns on saving) are xxxxx

2 components in investment spending

inventory investment and residential investment

desired national saving

level of national saving that occurs when aggregate consumption is at its desired level =Sd = Y-Cd-G

effect of fiscal policy, government purchases

more generally, because the decline in desired consumption can be expected to be less than the initial increase in government purchases, a temporary increase in government purchases will lower desired national saving. to summarize, for a given current level of output Y, we conclude that at temporary increase in government purchases reduces both desired consumption and desired national saving

taxes and desired capital stock

need to compare after-tax MPKf with uc if t is the tax rate on firm revenues, the after-tax future marginal product of capital is (1-t)MPKf. the desired capital stock is the one for which the after-tax future marginal product=uc (1-t)MPKf=uc MPKf= (uc)/(1-t) = (r+d)pk/(1-t)

uc

only when MPKf = xxx will the capital stock be at the level that maximizes its expected profit

investment tax credit

permits the firm to subtract a percentage of the purchase price of new capital directly from its tax bill

2 reasons to study investment behavior

1) investment spending fluctuates sharply over the business cycle, falling in recessions and rising in booms 2) investment plays a crucial role in determining the long run productive capacity of the economy