5.12, 5.13, 5.14 Current costs and future benefits: Understanding investment and asset prices

when should a firm undertake an investment project?

if and ONLY if:
X > I(1+r)

X = future profits

I = investment

r = interest rate

what does monetary policy rely on

(1) central bank being able to control interest rates

(2) changes in policy interest rates influencing market interest rates which affect AD and therefore inflation

asset prices

a decrease in interest rates means that asset prices will go up bc demand for them goes up —> households that own the assets feel wealthier so they spend more

investment

policy interest decreases —> market interest rates decrease —> firms and individuals will invest more in general

**however, firm investment is much less responsve to interest rates in general

nominal exchange rate (e)

number of units of home currency that have to be exchanged for one unit of foreign currency

Ex: if home country = australia…

e = # AUD / 1 USD

ex. if exchange rate = 1.54, then you can get 1 USD for 1.54 AUD. if a business in asutralia bought equipment costing 5000 USD from the US on that day, they’d pay 5000 × 1.54 = 7700 AUD

depreciation (exchange rates)

when the home country’s exchange rate (e) increases —> you need more AUD to buy the same amount of USD so the value of AUD decreases —> foreign currency costs more

when the home country’s exchange rate (e) decreases —> you need less AUD to buy 1 USD so the purchasing power has increased for AUD —> foreign currency costs less

real exchange rate

relative price of foreign and domestic G+S

RER = (e * P*) / P

e = nominal exchange rate

P = domestic prices

P* = foreign prices