Consumption & Consumption & InvestmentInvestment

Consumption & Consumption & InvestmentInvestment

SupplementSupplement

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:

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

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 schedule

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.

34$200,000 K

Optimal Capital: Example

Solve for Optimal Level of Capital

14

$150,000(.04 .08 .02) $1,000,000PMPK

K

14 * * 4$150,000

1.5 5.0625$100,000

K K

K

rck

K*

MPK

K

rck

K* K**

MPKMPK’

K

rck

K*

rck’

K**

MPK

Tax Rates

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 capital.

Tax Wedge, tw, is defined as the extra cost of capital

beyond the interest rate.

,1 2 3(1 ) (1 ) (1 ) (1 )

KP K NEWt tPMPK s i s s g P

,K

K

P K NEWt t

p Kt t

PMPK i g tw P

MPK r g tw p

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.

1 1

1

( )

1

( )

RE

REtREt

RE

P

P

P

R ck P Ri c tw g

Ri c tw

Real Estate Pricing

PRE

45%

P*

1 1

1

( )REtREt

P

P

Ri c tw

Calculating q: China Steel 2000

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 $19.5# of Shares 8,748,363,000Market Cap $170,593,078,500Book Value of PPE $118,415,993,000Total Debt $38,228,396,000Firm Value $208,821,474,500q 1.763456685

Adverse Economic Shock

Declining corporate net worth

Lower investment and reduced demand for real estate

Falling Real Estate Prices

Falling collateral values and worsening bank balance sheets lead to declining bank loans

Fire sales of commercial property to pay back bank loans leading to further declines in prices

The Financial Accelerator

K

rck

K*

MPK

K

rck

K*

MPK

K**

Change in Available Internal Funds

Conclusion

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 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.