Transcript Consumption & Investment

Consumption &
Investment
Supplement
Multiplier Effect
 An exogenous change in demand has
a larger effect on total demand, the
larger is the effect of current GDP on
consumption of domestic goods.
 If budget constraints or precautionary
savings are important then mpc may
be high and mpd high.
 If economy is very open, like HK
mpim may be high and mpd low.
Conclusion
 Consumption is major component of demand and moves
closely with business cycle.
 Perfect Lending Markets suggest:
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Consumption Choice should depend on the present value of
lifetime income.
Future changes in income should have roughly same
impact as future income.
Permanent increases in income should have a stronger
impact on consumption than temporary increases (which
should be largely saved).
 Permanent Income Hypothesis suggests:

Households consume annuity value of the sum of their
financial wealth plus their human wealth. This explains:


Small Wealth Effect
Demographic Behavior of savings.
Conclusion pt. 2
 Borrowing constraints and precautionary
savings suggest that consumption should
respond more to business cycle changes in
income than PIH argues.
 Interest Rates have ambiguous theoretical
impact on consumption and savings.
Empirically, the effect of interest rates on
savings is positive, but small.
 Degree of impact of current income on
consumption of domestic goods determines
multiplier
Real Estate
Chapter 23
Example
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A taxi agency can produce a certain
amount of revenue with larger numbers
of taxis (K = # of Taxis).
Assume earnings (revenues minus wages
minus costs) per year
is given by the
3
schedule $200,000 4 K
Assume that the purchase price of a new
taxi (with license) is $1,000,000. The
borrowing interest cost is 4% and a taxi’s
value depreciates by 8% per year. We
assume that taxi’s prices increase by 2%
per year.
Optimal Capital: Example

Solve for Optimal Level of Capital
PMPK 
$150, 000
1
4
 (.04  .08  .02) $1, 000, 000
K
$150, 000 14 *
 K  K *  1.54  5.0625
$100, 000
MPK
rck
K
K*
MPK
MPK’
rck
K
K*
K**
MPK
rck’
rck
K
K**
K*
Tax Rates
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Corporations frequently must pay taxes on earnings.
Define tax rate, .
Corporations also receive deductions for costs of
capital Define deduction rates = (s1, s2, s3, ….)
Maximize after-tax profits implies that after-tax
marginal product of capital = after-tax cost of
K
capital.
(1   ) PMPKt  (1  s1 )i  (1  s2 )  (1  s3 ) g P Pt K , NEW

Tax Wedge, tw, is defined as the extra cost of capital
beyond the interest rate.
PMPKt  i    g
MPKt  r    g
PK
pK
 tw Pt K , NEW
 tw ptK
Property the ultimate non-traded asset!
Cost of Capital Theory & Real Estate

Constructing New Buildings has long
lead times. For a fixed stock of
buildings we can use cost of capital
theory (y = ckRE) to derive prices as
a function of rents.
R  ck  P RE 

1
(i    c  tw  g
1
(i    c  tw 

Pt RE
1
Pt RE
)
1
R
P RE
R
)
Real Estate Pricing
1
(i    c  tw 

Pt RE
1
Pt RE
45%
PRE
P*

1 )
R
Calculating q:
China Steel 2000
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Market Capitalization =
Stock Price × # of Shares
Proxy for Replacement
Value of Capital – Book
Value of PP&E.
Proxy for Firm Value =
Market Capitalization +
Book Value of Total Debt
Caveat: Intangible Assets
(i.e. Technology) May Be
Large for Some Firms (e.g.
Acer Inc. has a 2000 q >
4).
Caveat: Book value of PP&E
may underestimate
replacement costs of capital
as it does not adjust for
inflation.

Firm Balance Sheets.
Stock Price
# of Shares
Market Cap
Book Value of PPE
Total Debt
Firm Value
q
$19.5
8,748,363,000
$170,593,078,500
$118,415,993,000
$38,228,396,000
$208,821,474,500
1.763456685
The Financial Accelerator
Adverse Economic Shock
Fire sales of commercial
property to pay back bank
loans leading to further
declines in prices
Falling collateral values
and worsening bank
balance sheets lead to
declining bank loans
Declining corporate net
worth
Lower investment and
reduced demand for real
estate
Falling Real Estate Prices
MPK
rck
K
K*
Change in Available Internal Funds
MPK
rck
K
K*
K**
Conclusion
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Cost of capital includes interest costs plus
depreciation costs plus capital losses plus tax
wedge.
Capital stock that maximizes profits sets the
marginal product of capital equal to the cost of
capital.
Business cycle fluctuations of capital investment
are due to fluctuations in productivity and cost of
capital.
Investment is volatile because capital is large
relative to investment in any given period. Small
fluctuations in optimal capital have large effects
on investment.
Conclusion pt. 2

Optimal Capital Theory implies
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Corporate Investment is a function of q
(market value of firm relative to the
replacement value of capital).
Real Estate prices are determined by rent
divided by the determinants of the cost of
capital.
In reality, internal funds are the dominant
source of finance for investment. External
Financing interest costs may depend on
the state of firms balance sheets.
Firms’ balance sheets are an additional
channel of business cycle volatility.