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Investment Notes

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Investment Topics

• Investment

• Investment Decisions in a Two-Period Model

• The q-Theory of Investment

• Investment Decisions

Reading

Investment

• Three different types of investment: a. Business fixed investment = Businesses' spending on equipment and structures for use in production b. Residential investment = Purchases of new housing units c. Inventory investment = The value of the change in inventories of finished goods, materials and supplies

Graph showing the different types of investment

Key Points

• Types of investment

• Decision to invest

• What determines expected future profit of capital investment

• Investment decisions in the two period model

• Intuitive approach to optimal investment decision

• Mathematical approach to optimal investment decision

• Investment demand curve

• q-theory of investment

• Intuition behind Tobin's q

• Mathematics behind Tobin's q

• Investment decisions

• Investments and asymmetric information Definitions

• Business fixed investment = Businesses' spending on equipment and structures for use in production

• Efficient market hypothesis = The price of a stock is equal to the PV of future expected dividends

• Inventory investment = The value of the change in inventories of finished goods, materials and supplies

• Residential investment = Purchases of new housing units

• Like consumers, firms are forward looking a. Investment decisions depend on expectations of the future
 Start here to explain investment theory

• Decisions to buy a machine depend on two things: a. PV of additional expected profits from having this machine b. The cost of buying it

• What determines the additional expected future profit of buying a machine?
a. MPK: a. If there is an improvement in technology then the MPK will be higher and profits will be larger b. Taxes:

• e.g. corporate income tax and investment tax credits Investment Decisions in a Two-Period Model

• Use the idea of a representative firm

• Use the Cobb-Douglas production function with TFP:

• Future output:

• Future capital stock:

• Current profits:

• Future profits:

• Remember in the final period we sell all capital less depreciation

• PV of profits:

• Tobin's q = The expected value of a corporation (value of stocks and bonds) divided by the value of its capital stock at replacement cost Formulae

• This is key to deciding on whether to invest Intuitive approach to optimal investment decision
○ Optimal employment decision:

○ Optimal investment decision:

○ We work in terms of units of investment ∴ MC(I)=1 and MB:

○ Simultaneous equations:


Mathematical approach to optimal investment decision
○ Choosing I is equivalent to choosing K'
○ Use the capital accumulation equation:

○ Firms have to choose 3 things to maximise I (N,N',K'):


○ Using the first order conditions:

Course Notes Page 33

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