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INVESTMENT (Continued…):Financing Constraints, Residential Investment

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Macroeconomics ECO 403
VU
LESSON 42
INVESTMENT (Continued...)
The Stock Market and Tobin's q
·  The term stock refers to the shares in the ownership of corporations
·  Stock market is the market in which these shares are traded.
·  The Nobel-Prize-winning economist James Tobin proposed that firms base their
investment decisions on the following ratio, which is now called Tobin's q:
q=
Market Value of Installed Capital
Replacement Cost of Installed Capital
The numerator of Tobin's q is the value of the economy's capital as determined by the
·
stock market. The denominator is the price of capital as if it were purchased today.
Tobin conveyed that net investment should depend on whether q is greater or less than
·
1.
·  If q >1, then firms can raise the value of their stock by increasing capital,
·  if q < 1, the stock market values capital at less than its replacement cost and
thus, firms will not replace their capital stock as it wears out.
Tobin's q and neo-classical model are closely related, since Tobin's q measures the
·
expected future profitability as well as the current profitability.
If the MPK exceeds cost of capital, the firms are earning profits on their installed
·
capital, making rental firms desirable to own, raising market value of stocks of such
firms, implying a high value of q
The Stock market as an Economic Indicator
·
Although the volatility of stock market can give false signals about the future of economy,
yet one should not ignore the link between the two.
·
Changes in stock market often reflect changes in GDP. whenever stock market experiences
a substantial decline, we should be ready for an upcoming recession.
·
Why do stock prices and economic activity tend to fluctuate together?
·
Tobin's q and AD-AS Model
­ Suppose there occurs a fall in stock prices. Since replacement cost of capital is stable,
this will result in a fall in Tobin's q, reflecting investors' pessimism about the current or
future profitability of capital.
·
Some Additional Reasons
­ A fall in stock prices makes people poorer, depressing their spending, resulting in
reduced aggregate demand
­ Fall in stock prices reflect bad news about technological progress and economic growth,
resulting in slow expansion of natural rate of output.
Financing Constraints
·
When a firm wants to invest in new capital, e.g. by building a new factory, it raises the funds
in financial markets by
­ Obtaining loans from banks
­ Selling bonds to public
­ Selling shares in future profits on stock market
·
Neo classical model assumes that if a firm is willing to pay cost of capital, financial markets
will make the funds available.
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Macroeconomics ECO 403
VU
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But sometimes firms face Financing constraints, limiting the amount of funds they can raise
from financial market.
·
So the amount a firm can spend on new capital goods is limited to the amount it is currently
earning.
·
For example, a recession reduces employment, rental price of capital and profits. If the firm
expects the recession to be short lived, it will continue investing for long term profitability,
thus having a small effect on Tobin's q.
·
So the firm that can raise funds in financial markets will face a small effect of recession on
the investment.
·
While incase of firms facing constraints, the fall in current profits restrict the spending on
new capital goods and may prevent such firms from making profitable investment.
Residential Investment
We will now consider the determinants of residential investment by looking at a simple model
of the housing market. Residential investment includes the purchase of new housing both by
people who plan to live in it themselves and by landlords who plan to rent it to others.
To keep things simple, we shall assume that all housing is owner-occupied.
There are two parts to the model:
1) The market for the existing stock of houses determines the equilibrium housing price
2) The housing price determines the flow of residential investment.
·
The relative price of housing adjusts to equilibrate supply and demand for the existing stock
of housing capital.
·
Construction firms buy materials and hire labor to build the houses and then sell them at
market price.
·
Their costs depend on the overall price level P while their revenue depends on the price of
houses PH.
·
The Higher the PH, the greater incentive to build house.
Market for Housing
Supply of New Housing
PH/P
Relative
S
Price
of housing
PH/P
D
Stock of housing capital, KH
Flow of residential investment, IH
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Macroeconomics ECO 403
VU
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This model of residential investment is much similar to q theory of business fixed
investment, which states that business fixed investment depends on the market price of
installed capital relative to its replacement cost, which in turn depends on expected profits
from owning installed capital
·
The residential investment depends on the relative price of housing, which in turn depends
on demand for housing, depending on the imputed rent that individuals expect to receive
from their housing
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand