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Lecture 41

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17 views

Lecture 41

Uploaded by

abaidullah bhatti
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPS, PDF, TXT or read online on Scribd
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Review of the Previous

Lecture
• Investment
– Business Fixed Investment
• Rental Price of Capital
• Cost of Capital
Topics under Discussion
• Investment
– Business Fixed Investment
• Cost of Capital
• The Determinants of Investment
• Taxes and Investment
• The Stock market and Tobin’s q
The Cost of Capital

Total cost of capital = iPK - PK + PK


= PK (i - PK/PK + )

The cost of capital depends upon the price


of capital, the interest rate, rate of change
of capital prices and the depreciation rate.
The Cost of Capital
• Assuming price of capital goods rises with the
prices of other goods, so

Pk/Pk = overall inflation rate, 


Since,
r = i - ,

Cost of Capital = Pk(r +)


The Cost of Capital
• To express the cost of capital relative to other
goods in the economy.
• The real cost of capital-- the cost of buying
and renting out a unit of capital measured in
terms of the economy’s output is:
Real Cost of Capital = (PK / P )(r + )
where
r  the real interest rate
PK / P  the relative price of capital.
The Determinants of
Investment
• Now consider a rental firm’s decision about
whether to increase or decrease its capital stock.
• For each unit of capital, the firm earns real
revenue R/P and bears the real cost (PK /P)(r+).
• The real profit per unit of capital is
Profit rate = Revenue - Cost
= R/P - (PK /P) (r+).
• Because real rental price equals the marginal
product of capital, we can write the profit rate as
Profit rate = MPK - (PK / P )(r + )
The Determinants of
Investment
• The change in the capital stock, called net investment
depends on the difference between the MPK and the cost
of capital.
– If the MPK exceeds the cost of capital, firms will add to their
capital stock.
– If the MPK falls short of the cost of capital, they let their capital
stock shrink.
– Thus:
K = In [MPK - (PK / P )(r + )]
– where In ( ) is the function showing how much net investment
responds to the incentive to invest.
The Investment Function
We can now derive the investment function in the
neoclassical model of investment. Total spending
on business fixed investment is the sum of net
investment and the replacement of depreciated
capital.
The investment function is:
I = In [MPK - (PK / P )(r + )] + K

the cost of capital


depends on
amount of depreciation
investment marginal product of capital
The Investment Function
• This model shows why investment depends on
the real interest rate.
• A decrease in the real interest rate lowers the
cost of capital. It therefore raises the amount of
profit from owning the capital and increases the
incentive to accumulate more capital.
• Similarly an increase in real interest rate raises
cost of capital and leads the firms to reduce their
investment.
The Investment Function
I as r ,hence
the downward slope
of the investment Real interest
function. Also, an rate, r
outward shift in the
investment function
may be a result of
an increase in the
marginal product of
capital. e.g. a
technological
Investment, I
Innovation
The Investment Function
• Finally, we consider what happens as this
adjustment of the capital stock continues over
time.
• If the marginal product begins above the cost
of capital, the capital stock will rise and the
marginal product will fall.
• If the marginal product of capital begins below
the cost of capital, the capital stock will fall
and the marginal product will rise.
• Eventually, as the capital stock adjusts, the MPK
approaches the cost of capital.
The Investment Function
• When the capital stock reaches a steady state level,
we can write:

MPK = (PK / P )(r + )

• Thus, in the long run, the MPK equals the real cost
of capital. The speed of adjustment toward the
steady state depends on how quickly firms adjust
their capital stock, which in turn depends on how
costly it is to build, deliver and install new capital.
Taxes and Investment
• Tax laws influence the firms’ incentives to
accumulate the capital in many ways.
• Sometimes policymakers change the tax
laws in order to shift the investment
function and influence aggregate demand.
• Here we discuss two of the most important
provisions of corporate taxes:
– Corporate Income Tax
– Investment Tax Credit
Taxes and Investment
• Corporate income tax is a tax on corporate
profits, and its effect on investment depends on
how the law defines profit for the purpose of
taxation.
• Suppose, at first, the law says:
Profit rate = R/P - (PK /P) (r+)
• In this case, even though firms would be
sharing a fraction of their income with the
government, it would still be rational for them to
invest if
R/P > (PK /P) (r+)
Taxes and Investment
• But in reality the definition of law is quite
different than this.
– Treatment of depreciation
• Theoretically: current value of depreciation
• Tax laws: depreciation at historical cost
Taxes and Investment
• The Investment Tax Credit is a tax provision
that encourages the accumulation of capital. It
reduces a firms taxes by a certain amount for
each unit of money spent on capital goods.
• Since the firm recoups part of its expenditures
on new capital in lower taxes, the credit
reduces the effective purchase price of a unit of
capital Pk. Thus reducing the cost of capital and
raising investment.
Swedish Investment Funds
System
• Tax incentives for investment are one tool policy
makers can use to control aggregate demand.
• For example, an increase in the investment tax
credit reduces the cost of capital , shifts investment
function upward, and raises the aggregate
demand.
• From mid-50s to mid-70s the govt. of Sweden
attempted to control aggregate demand by
encouraging or discouraging investment, through a
system called Investment Fund subsidized
investment
Swedish Investment Funds
System
• In case of economic slowdown, the authorities
offered a temporary investment subsidy, and in
case of economic recovery, revoked it.
• Eventually subsidy became a permanent
feature of Swedish tax policy.
Summary
• Business Fixed Investment
– Cost of Capital
– The Determinants of Investment
– Taxes and Investment
Upcoming Topics
• Business Fixed Investment
– Financing Constraints
• Residential Investment
• Inventory Investment
– Seasonal Fluctuations and Production
Smoothing
– Accelerator Model of Inventories
– Inventories and Real interest Rate

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