ECON 2105: Investment

Investment

purchases of new capital, which increase/expand the economy’s productive capacity

adds to the capital stock

fluctuates dramatically as business conditions change

capital

assets that are used repeatedly to produce output

Examples of investment

purchases of new:

business equipment

offices and factories

research and development for new software

Trading an existing asset

does not count as investment

simply reshuffles who owns what:

buying stocks

buying a used car

buying bitcoin or other financial assets

Capital stock

the total quantity of capital at a point in time

depreciation decreases this term

this term increases when investment exceeds depreciation

Depreciation

the decline in capital due to wear and tear, obsolescence, accidental damage, and aging

Types of Investment

business

housing

inventories

Business investment

the money that businesses spend on new capital assets

these assets include:

equipment

structures

intellectual property

Accounts for the bulk of investment in the economy

Housing investment

the money spent on building or improving houses or apartments

increases the economy’s capacity to generate rent

existing homes don’t count as macroeconomic investment because they don’t create any new capital

Inventories

business maintain inventories of raw materials, work in progress, and unsold goods

An increase in inventories is counted as investment

• tiny share of total investment

• volatile

Investment is sensitive to

future expectations

interest rates

lending standards

Investment drives long term prosperity

countries with more capital per worker produce more output per worker

Evaluating Investment Decisions

figure out how to value today’s costs relative to future benefits

• apply cost benefit principle

• compare values at different points in time

• opportunity cost of an investment project is the foregone interest

Two analytical tools: compounding and discounting

Investment Tool 1 :Compounding

the accumulation of money over time, as you earn interest on both your principal and accrued interest

you earn interest not only on your initial deposit but also on previously earned interest, so your wealth compounds over the years

Compounding Formula

Future Value = Present value x (1 + decimal rate)^number of years

Future value

the amount that our money will grow into by a specific future date, as a result of accumulating interest

Investment tool 2: Discounting

converting future values into their equivalent present values

present value

the amount of money that you would need to invest today in order to produce a specific benefit in the future

Discounting Formula

Present Value = Future Value in t years/(1+decimal rate)^number of years

Nominal values

refer to the number of dollars you have; to assess _________ of your funds, use the nominal interest rate in the compounding or discounting formula

Real values

adjust for inflation; to asses the ________ of your funds, us the real interest rate in the compounding or discounting formula.

Focuses on your purchasing power

Evaluating an Investment Opportunity

1. Calculate the up-front cost

2. Predict future profits, taking account of depreciation

3. Calculate the present value of all benefits and costs

4. Invest if the present value of benefits exceeds the present value of costs

Formula for Future Revenue

Last year’s revenue x (1 - decimal depreciation)

Formula for Present Value of Payments or Future Profits

(next year’s profit)/(decimal rate + decimal depreciation)

Rational rule for investors

pursue an investment opportunity if the present value of future profits is greater than (or equal to) the up front costs, C.

Marginal Benefit

defined as next year’s profit

• an extra machine will generate extra output, and hence, profit

Formula for expected loss due to foregone interest

decimal depreciation x up front costs (C)

Formula for expected loss due to foregone interest

decimal rate x up front costs (C)

Formula for Marginal Cost

(decimal rate + decimal depreciation) x up front costs (C)

Marginal Costs

Consider both depreciation and foregone interest of an extra unit of capital

• when you sell capital equipment a year later, it will be worth less (expected loss due to depreciation)

• When you buy capital equipment, you’re tying up your funds for a year (expected loss due to foregone interest)

user cost of capital

the extra cost associated with using one more machine next year

sometimes called the rental cost

Total investment

sum of all individual investments in the economy

Investment will depend on

1. expectations about future profits

2. Real interest rate, r

3. Depreciation rate, d

4. Real cost of capital, C

Higher Real interest rates

lead managers to invest less in buying new capital because their next best alternative is leaving their money in the bank to earn interest

result in higher opportunity cost and a smaller chance that the investment project will pass the cost-benefit test

Investment declines

occurs when the real interest rate rises

the higher the real interest rate, the lower the present value of future profits, so fewer investments will pass the cost benefit test.

A change in real interest rates causes a movement along the investment line

Four investment Shifters

1. Technological advances

2. Expectations

3. Corporate Taxes

4. Lending standards and cash reserves

Technological Advances

make capital equipment more productive, boosting profits and making investment more attractive at any given interest rate

reduce the depreciation rate and boots future outputs and profits

• makes the investment more attractive at any given interest rate

these advances shift the investment line to the right

Expectations

if managers are optimistic about future economic conditions

• they forecast that new investments are likely to yield robust profits

• so they invest more (investment line shifts right)

If managers are pessimistic about future economic conditions

• they invest less (investment line shifts left)

Corporate Taxes

when these are high, companies keep a smaller share of future profits

• reduces the profits they keep from investment, causing companies to invest less (shifting curve left)

tax breaks

• increase revenue, and hence, profits leading to grater investment (shifting curve right)

Lending Standards and Cash Reserves

Investment challenge: How will you finance your new investment?

How will you get the cash to pay for new capital?

• Borrow the funds from a bank

• Use the company’s cash reserves

More investment when

• companies face less restrictive lending standards

• or when they have enough cash reserves

Long Run real interest rate

evolves slowly over many years in response to the balance of saving and investment

Short Run real interest rate

rises and falls each month with adjustments from the Federal Reserve

Market for Loanable Funds

the market for the funds used to buy, rent, or build capital

Brings together savers (suppliers) who want to lend their funds and investors (demanders) who want to borrow funds

Determines the long run real interest rate (price of a loan) and the quantity of investment

Neutral real interest rate

the interest rate that operates when the economy is in neutral - producing neither above nor below its potential

A decrease in saving

shifts the supply of loanable funds to the left, leading to a higher interest rate

An increase in saving

shifts the supply of loanable funds to the right, lowering the real interest rate

Determinants of the Supply of Loanable Funds

1. Private Savers

2. The government’s savings

3. Foreigners’ savings

Personal saving

personal saving = saving by households of whatever income they don’t spend or pay as taxes

• putting money in the bank

• paying down your debt

  • frees up loanable funds for others to use

Changes in Private Savers

anything that shifts people’s willingness to save will shift the supply of loanable funds

Changes in the government’s savings

Government saving shifts due to changing budget surpluses and deficits

Budget Surplus

when government revenues exceed outlays

these extra funds are typically used to repay government debt which frees up those funds for others to borrow

increases the supply of loanable funds available (causing a rightward shift in supply of loanable funds)

Budget deficit

when the government spends more than it takes in

the government borrows by issuing bonds, which people and businesses buy with their savings

causes less savings, leading to a decrease in the supply of loanable funds (leftward shift)

Budget deficit can cause

crowding out: the decline. in private spending, and particularly investment, that follows from a rise in government borrowing

Foreign Savings

AKA net financial inflows

the funding that comes from foreigners lending money to Americans

Determinants of demand for loanable funds (investment)

1. Technological Advances

2. Expectations

3. Corporate Tax Cuts

4. Easier lending standards + larger cash reserves (2)