Macroeconomic Theory
Investment
Agenda
1
Investment
2
Readings
3
Review and To Do
Attendance
Investment
What determines investment spending?
- Focus for a minute on investment in structures, equipment, software and R&D by private businesses (business fixed investment)
Firms must consider:
- cost of the investment
- cost of obtaining funds
- opportunity cost of funds
- predictions of future prices and demand
And all of this occurs at different dates!
Expected income
Firms must not only predict the stream of future income
- this expectation is precarious
The stream of income must also be valued in the present
The cost of investment
Two key costs:
costs of equipment
costs of funds
there are costs whether the funds come from internal reserves or external sources
Sources of Funds
Retained earnings
Borrowing via bank loans
Borrowing via other debt instruments
Selling new equity shares
Borrowing sets up a stream of cash payments that legally need to be met
Discussion
Would you prefer $ 2 million when you retire in 45 years,
or $80,000 today that’s put into a bank account to
compound for the next 45 years? Explain in detail.
Compounding
The opportunity cost of an up-front investment is what would happen to that money if you put it somewhere to accumulate interest.
The amount that your money will grow into by a future date, as a result of earning interest, is called its future value.
\[ \text{Future value in t years} = \text{Present value} \times (1+i)^t\]
Discounting
The amount of money that you need to invest today in order to produce an equivalent benefit in the future is a present value.
Converting future values into their equivalent present values is called discounting.
Present value calculations
A simple version of a present value calculation would be a one time payment:
\[ \text{Present value} = \text{Future value in t years} \times \frac{1}{(1+i)^t} \]
Present value
- But investment calculation typically involves understanding the present value of a future stream of payments
\[ PV = \frac{Payment_{t+1}}{(1+i)} + \frac{Payment_{t+2}}{(1+i)^2} + \frac{Payment_{t+3}}{(1+i)^3} \]
- where \(i\) is the risk free rate of interest that you could get by loaning the money out
Present value
\[ PV = \frac{Payment_{t+1}}{(1+i)} + \frac{Payment_{t+2}}{(1+i)^2} + \frac{Payment_{t+3}}{(1+i)^3} \]
we would also want to modify this for the degree of risk/uncertainty
a firm can then compare the cost of funds to the expected present value of an investment good
The Interest Rate
It is common in macroeconomics courses to suggest that investment spending is inversely related to “the” rate of interest
As “the” rate of interest rises, both the cost of borrowing AND the opportunity cost of retained earnings rises
When compared with the present value of investment projects, this means that some projects will no longer have a present value that exceeds the cost of funds
The Interest Rate
You can use either interest rate in the compounding and discounting formulas:
If you’re evaluating the nominal value of your funds (how many bills you’ll have in a few years’ time), use the nominal interest rate.
If you’re evaluating the real value of your funds (changing purchasing power, after adjusting for inflation), use the real interest rate.
In practice, it is often hard to predict the relevant inflation rate over the life of an investment so real interest rates are very provisional.
How Sensitive is Investment to Interest Rates?
a common finding empirically however is that investment is not particularly interest elastic
Gormsen and Huber (2022) combed through “earnings calls” and flagged any mention of the hurdle rate or required return on new capital projects.
Hurdle rates are the minimum rate of return a business requires to undertake an investment project
They found that the hurdle rates were very high (15-20%) and did not seem to move with current interest rates
alternatively, housing investment (particularly by individuals) does seem to be fairly interest sensitive
Current income and investment
empirically, measures of current income and cash flow seem to exert a strong influence on business investment
this could be because cash flow is a source of funds, an indicator of credit quality, or serves as a predictor of future sales
- evidence for all three
this would imply a large multiplier than before since investment is responsive to current income
- it also suggests a link between short and long run economic performance
Financing Investment
Firms can finance investment through:
retained earnings
borrowing (issue bonds, or obtain bank loans)
equity (issue new shares)
Borrower and Lender’s Risk
If a firm uses retained earnings, it faces the opportunity cost of outstanding long-term debts (bonds) that it could have invested in.
If a firm borrows it will likely find that the more it borrows, the higher the rate it must pay
- lower cash flow ratio to fixed investment
- moral hazard
- note also the premium may change!
If a firm issues new equity, it may be expected to pay dividends (which have different tax treatment than interest payments), and as it issues more, outstanding shares are diluted.
Hierarchy of finance
Review and To Do
Review
Today we looked at some more complicated theories of consumption that argue consumers think about the future
- we found that while that is likely true, they are limited in their ability to bring future income into the present
We also got an introduction to the data and some elements of the investment decision
- we found that firms should respond to interest rates in theory, but don’t seem to in practice
- we also found that firms don’t consider all forms of finance equal
Readings
Do interest rates really drive the economy?
Two problems on the effectiveness of central bank interest rate policy - market rates don’t always follow Fed policy rates (we will discuss later ) - changes in interest rates don’t seem to have large effects on investment
Do interest rates really drive the economy?
relies on the Gormsen and Huber article we discussed earlier
In practice, business investment seems to depend much more on demand growth than on the cost of capital.
- can lead to vicious or virtuous spirals
all of this however suggests that the Fed may have a hard time controlling the economy
Interest rates just keep falling
When the C.B.O. projects how legislation will affect the economy, it assumes that when the government borrows more, higher deficits will cause interest rates to rise, crowding out investment by the private sector.
This has been orthodoxy and has been in intermediate macro courses forever, but it doesn’t seem to work in practice!
We will spend quite a bit of time discussing why it doesn’t work, but we might already have one version of an answer….
Crowding In and the Paradox of Thrift
If demand (output/income) drives investment more than interest rates, government spending might actually “crowd in” private investment!
Alternatively, when governments cut budget deficits - it seems to have a dampening effect on private investment.
Next time
Read:
Central Banking 101, Ch. 1-2
Money Creation in the Modern Economy
Do:
Homework 5