Economics 122. Investment Fall 2013

1. Economics 122. Investment Fall 2013 NOAA’s weather supercomputer PET Scan of PIB molecule

2. Midterm results • Overall: bimodal distribution. Many of you are apparently engaged in irrational procrastination and suboptimal study habits: • Problem sets • Lectures • Grade distribution. Roughly evenly distributed within segments.

3. The Macroeconomics of Investment Capital • Produced, durable, used for further production • Examples: • tangibles (structures, equipment) • intangibles (software, human capital) Basic role of investment in macro • Short run: most volatile part of aggregate demand • See next slides • Long run: key determinant of growth of potential output and major way that governments affect economic growth • In growth theory

4. Why is investment an inverse function of r? r = real interest rate E I(r) Investment (I)

5. Gross Investment, US, 2010 Counted as investment in National Accounts Sector 2010 % of GDP GROSS DOMESTIC PRODUCT 15,076 100.0 Total, investment type 39.6 Residential/Household 1,485 9.9 Durable goods 1,146 Residential structures 339 Gross busines domestic investment 1,516 10.1 Fixed investment 1,480 Structures 405 Equipment and software 1,075 Change in private inventories 37 Government gross investment 480 3.2 Federal National defense 109 Nondefense 52 State and local 320 Other investment-type private spending 2,484 16.5 Health 1,752 Private education 252 Research and development 480 National accounts include only a small part of “investment-like” spending: 12% of 40%.

6. Investment decline in the Depression Note on data: Very convenient place is “FRED”: http://research.stlouisfed.org/fred2

7. Investment in the Great Recession This is only gross domestic private investment.

8. Today’s housing depression

9. Housing and interest rates with tight money

10. The major theories of investment 1. Neoclassical theory: Desired capital stock a function of output and cost of capital 2. Q theory: Investment a function of Tobin’s Q (Q =ratio of market value of K to replacement cost)

11. - L Cobb-Douglas in neoclassical K Production underlying neoclassical theory

12. Investment Criteria User cost of capital, uc • Central concept in macro theories of investment • Definition. Cost of renting capital for one period • Appropriate for perfect capital market where Q=1* • Estimate as imputed in most circumstances because firms own capital (also for housing in NIPA) * We will see later that Q = market value/replacement cost.

13. Formula for cost of capital uc ≈ (1+τ) pK [r + δ] whereuc = user cost of capitalpK = price of capital goodr = real interest rateδ = depreciation rateτ = effective rate of tax (or subsidy when negative) on capital goods Linkage to policy:- through real interest rate- through taxation of capital In practice, uc is complicated to measure; off to B School!

14. Derivation and example: • Buy a car, rent it for one period, and then sell at the end. No inflation or taxes. Real interest rate = r = .05. • Pay $20,000 sell for 20,000(1-.1) = $18,000; collect rent u. • What cost of capital (u) would just break even? when pK = pK (1- δ)/(1+r) + u20,000 = 18,000/(1.05) + uuc = 20,000 – 18,000/1.05 = 20,000 – 17,143 = 2857 ≈ pK (r+ δ) = 20,000(.15) = 3,000

15. Cost of capital with no taxes and P = 1 This is a slightly more realistic version that has both debt and equity capital.

16. Derivation of Basic Theory • Define the user or rental cost of capital as uc = (r+δ) PK as implicit rental on capital. • Assume that Y is given by short-run aggregate demand • Cobb-Douglas for simplicity and pK = p = 1. • So the demand for investment is; • proportional to output • inverse to the user cost of capital, and therefore also to the interest rate.

17. Note that the impact of interest rates on investment is powerful but depends importantly on the lifetime of the capital: • Where biggest impacts? Housing. Why? • Where smallest? Computers and inventories. Why?

18. From demand for capital to demand for investment • Note that this is the demand for capital out of equilibrium. • Generally, go from demand for capital to demand for investment • Several approaches: • Costs of adjustment of investment (standard in modern macro) • Capacity in the capital goods industry (Boeing aircraft) • Construction lags (power plants) • Internal funds constraint

19. Now a major puzzle for neoclassical model:housing and interest rates Housing price crash Tight money ?

20. The major theories of investment 1. Neoclassical theory: Desired capital stock a function of output and cost of capital 2. Q theory: Investment a function of Tobin’s Q (Q =ratio of market value of K to replacement cost)

21. A glut of cargo ships in 2009

22. Airplanes in mothballs (Tucson, Arizona)

23. More formally: Q = (market value of K)/(replacement cost of K) Example: - Cargo ships are selling for a Q of 0.25 - E.g., cost of production is $20 million, but ships sell for $5 million - How is this possible? • Inelastic supply and high demand for cargo → low rentals • PV of ships is low. • Therefore, little to no shipbuilding, and the stock gradually depreciates or is scrapped How does Q affect investment? - Because Q < 1, shipping firms buy old ships rather than build new ones - This depresses investment. - Therefore I/K = f(Q), f’(Q) > 0.

24. 3. Q theory of investment Idea here is that investment is determined by relationship between the value of firms or houses and the cost of new or replacement capital. Keynes: “The daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.” Tobin: "It is common sense that the incentive to make new capital investments is high when the securities giving title to their future earnings can be sold for more than the investments cost, i.e., when q exceeds one."

25. Investment and Q Q I/K = f (Q) 1 I/K δ

26. Housing market collapse, 2006 – 2013+

27. Investment ratio and Q for housing • Housing bubble: • Note that Q rose about 50 percent from mid-1990s. • Note huge decline in residential construction (I)

28. Housing Q and housing starts, 2006:m1 – 2010:m7

29. Summary of investment theory 1. The major components of investment are residential, business plant and equipment, software, and inventories. 2. These are among the most volatile components of output in the short run. 3. In equilibrium, demand for capital determined where the cost of capital equals the marginal productivity of capital. 4. The major theories are the the neoclassical theory and the Q theory. These apply differently in different sectors. 5. Economic policy affects investment through both monetary and fiscal policy: • monetary policy through real interest rate and unconventional policies (buying mortgage backed securities) • fiscal policy through things like depreciation policy and investment tax credits.