basic theory of investment - will invest if present value of future profits exceeds cost
- depreciation - determines how long machine will last
- depreciation rate (d) - how much less useful a machine gets after a year
- V(Pt)= Pt+1 / (1+rt) + Pt+2(1-d) / [(1+rt)(1+rt+1)] + ...
- V = present value of expected profits (P)
- this model assumes that there are no profits in the first year and doesn't start depreciating until after year 1
- It = I( V(Pt) )
- simple model
- investment depends positively on expected present value of future profits
- assume constant interest and profits (static expectations)
- Pt+2 = Pt+1 = Pt
- rt = rt+1
- V(Pt) = Pt / (rt+d)
- user cost (rental cost of capital) - rt+d
- each year company would charge real interest and amount that machine will depreciate for use of machine (at the very least)
current profit vs expected future profit
- investment strategies change according to current profit, not just expected
- relation between future expected profits and current profits
- low current profit >> firms less willing to borrow to buy new machines, even if expected profits are high
- lenders also reluctant to give money to firm w/ low profits
- It = I(V(Pet) , Pt)
- investment depends positively on both expected present value of future profits and current level of profit
profit and sales - determined by level of sales and capital stock
- Pt = P(Yt/Kt)
- for constant sales, higher capital stock >> lower profit
- for constant sales, lower capital stock >> higher profit
volatility of consumption vs investment
- consumption, investment usually move together
- w/ income increase (positive IS shift), consumption increases at most 1 to 1
- increase consumption more than income increase >> would have to cut consumption later
- increase in investment can be greater than increase in sales
- company moves quickly >> large, short investment spending increase
- higher investment >> higher capital stock (K) >> Y/K goes back to normal >> investment goes back to normal
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