65ECON110B IV. Expectations and Investment •To show how investment decisions depend on current and expected profits, and on current and expected real interest rates •To look at the movements in investment over time 1. Investment behavior •Basic theory of investment: the present value of profits the firm can expect from having this additional machine - Present value of profits vs. the cost of buying the machine - The role of expectations 1) Investment and expectations of profit a. To determine whether to buy a new machine b. Depreciation - As time passes, more and more expensive to maintain and less and less reliable - Assumption: a machine loses its usefulness at rate δ- Numbers between 4% and 15% for machines and between 2% and 4% for buildings and factories 66c. The present value of expected profits - Assumption: a machine bought in year tbecomes operational and starts depreciating only 1 year later, in year t + 1. - Π: real profit per machine i) The present value, in year t, of the expected profit in year t + 1: - ettr111+Π+- Πet+1: Expected profit in year t + 1ii) The present value of the expected profit in year t + 2: - etettrr21)1()1)(1(1++Π−++δ- Πet+2: Expected profit per machine in year t + 2- Depreciation: Only (1 - δ) of the machine is left in year t + 2- (1 - δ) Πet+2: Expected profit from the machine in year t + 2Computing the present value of expected profits
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