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ch14 - CHAPTER 14 INVESTMENT SPENDING Solutions to the...

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CHAPTER 14 INVESTMENT SPENDING Solutions to the Problems in the Textbook : Conceptual Problems: 1. Even if the economy has achieved the desired capital stock some (gross) investment still must take place to keep the capital stock at this level. The level of investment has to be sufficient to cover depreciation (due to wear and tear or because capital becomes obsolete). 2. High-tech capital (such as computers) becomes obsolete at a very fast rate and therefore needs to be replaced much earlier if firms want to stay competitive. Therefore the rate of depreciation will increase if more is invested in high-tech machines. Human capital also depreciates since knowledge tends to become outdated (new theories are advanced and new discoveries are made continuously). Thus knowledge needs to be updated. Who for example, wants to be treated by a physician who hasn't kept up with new advances in medical technology? Similarly, since one can also think of health as human capital, we can see that, as we grow older, our stock of health tends to depreciate. But the more we invest in health, that is, the healthier we live and the more preventive measures we take, the slower this stock of human capital will depreciate. 3. The interest rate cannot simply be considered as the rental cost of capital but is also an opportunity cost. Retained earnings can be used to invest in new machinery but also to make a loan to someone else. In other words, at any time retained earnings can be "financially invested," that is, given to someone in need of funds (the government, for example), in which case these funds would earn interest. For example, if the yield on a government bond or a commercial paper is much higher than the expected rate of return on an investment in real capital, a firm may not want to undertake this investment and "invest" in a government bond. 4. The price of a share of stock in a company should, in an efficient stock market, be equal to the price of a claim on the capital in the company. Tobin’s q is an estimate of the value the stock market places on a firm’s assets relative to the cost of producing those assets. In other words, it can be thought of as the ratio of the market value of a firm to the replacement cost of capital. The replacement cost of capital is a measure for the marginal cost of capital. If q is greater than 1, then a firm should add physical capital, since for each dollar’s worth of new machinery the firm can sell stock for q > 1 dollars. But this means that the marginal product of capital exceeds its marginal costs. 5. A sudden increase in the demand for a firm's product will increase expectations of future sales and induce a firm to increase its desired capital stock. This will require an increase in net investment. The speed with which the capital stock is increased to its new desired level depends on whether the firm 216
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believes that the increase in sales is permanent or temporary and on the cost to the firm of adjusting the capital stock to its new desired level quickly.
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