MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 11/27/2018 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Investment PowerPoint by Beth Ingram University of Iowa Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Key Concepts Volatility of investment Role of Savings Cost of Capital Explanations for investment behavior q-theory Tax wedges

1987 Consumption Investment Government Spending 2000 Source: NIPA

Investment as Proportion of GDP

Investment as Proportion of GDP

German Investment and GDP Growth over the Cycle Real GDP

Investment, Savings and the Interest Rate Recall ideas from Chapter 4 Savings Private Public

Review (Ch. 4)  Capital means  MPk Marginal Product of Capital  R Output  Capital means  MPk Capital Stock Marginal Product of Capital  R R means  MPk means  Capital (i.e., at lower interest rate can afford to have higher capital stock)

Determination of Investment Cost and Marginal Return Cost of Capital Marginal Product of Capital K0 Capital Stock

Cost of capital falls Investment Rises Cost and Marginal Return Marginal Product of Capital K0 K1 Capital Stock Investment Rises

Cost of capital rises Investment Falls Cost and Marginal Return Marginal Product of Capital K1 K0 Capital Stock Investment Falls

Increase in MPK Cost and Marginal Return Cost of Capital Marginal Product of Capital K0 K1 Capital Stock

Cost of Capital Cost of using funds Changes in value of capital Interest rate Risk Changes in value of capital Depreciation Change in resale price

Investment 6% Interest Rate 5% Investment 8% 10% Percentage of Income

Savings 6% Interest Rate 5% 10% 12% Percentage of Income Savings 11/27/2018 Savings Savings 6% Interest Rate 5% The following model isn’t in the book explicitly, but I like to present it because it gives students a framework in which to think about the relationship between investment and savings. It makes use of groundwork laid elsewhere. 10% 12% Percentage of Income

So how is the interest rate determined? 11/27/2018 So how is the interest rate determined? What factors influence the “r”? Time period Risk Type of capital Type of financing – argue that interest rate is good proxy Tax issues

In equilibrium… Savings 6% Interest Rate 5% Investment 5% 10% 12% Percentage of Income

In equilibrium… Savings Interest Rate 5% 4% Investment 10% 14% Percentage of Income

Suppose increase in TFP 11/27/2018 Suppose increase in TFP r Savings 6% 5% Investment What else increases investment demand? Must increase the MP of capital Tax incentives Increase in quantity of labor Shift in goods towards capital-intensive production 10% 12% Percentage of Income

Japan In 1998, Japanese households increased the share of their incomes that they put into savings from an average rate of 12% in 1990-96 to 15-16%. They have begun to save a little less; the rate dropped below 15% in 1999.

Suppose declining savings 11/27/2018 Suppose declining savings Savings 5.5% Interest Rate 5% Investment What shifts the savings supply curve? Must change consumption today relative to consumption tomorrow. Changes in current income (more current income means more savings) Changes in future income (less future income means more savings) Tax effects 8% 10% Percentage of Income

q theory of investment q = Stock Valuation Replacement Cost Value of company on the stock market Replacement cost of company capital Stock Valuation q = Replacement Cost

What does it say? Stock Valuation > Replacement Cost Increase Investment Stock Valuation < Replacement Cost Decrease Investment

Cash Flow and Investment Cash Flow story Investment is determined by current profits High current profits mean high investment Implications for optimal investment

Lumpy Investment Investment spending tends to be concentrated in a relatively small span of time at the firm level In aggregate, tends to coincide with the cycle Two views Keynes: waves of optimism and pessimism Real Business Cycle: optimal response to technological shifts

Foreign Direct Investment (FDI) Flows of capital between countries Increasing importance in world investment Generated by cross-country differences in Marginal Product of Capital Cost of Capital

Tax wedges on machinery investment, 1996

Tax wedge on inventory investment, 1996

Tax wedge on building investment, 1996

Intangibles Assets that do not have a physical representation Brands Copyrights Technological know-how Valuable to firm, hard to measure One measure: difference between market value of assets and cost of physical assets Relationship to Tobin’s q

Summary Role and characteristics of investment Cost of capital and MPK Volatile Pro-cyclical Cost of capital and MPK Tobin’s q FDI Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.