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Unformatted text preview: Life cycle theory of consumption
 incomes different in
 account for consumption Permanent income hypothesis
 is key
 Ct based on longterm income
 does not change with
 wealth made up of: o : constant proportion consumed
o : does not impact consumption
Investment
 investment in , not ﬁnancial, assets  how do ﬁrms decide whether to purchase capital?
 still based. on
o augment with rate,
PDV of stream of compare it with the l.estimate
o 5 =
2. compute PV of
 purchase in period. t: factory built, machine installed  operating in :ﬁrst “:1 earned
 discounted. PV of proﬁts:  account for depreciation in t+2:  putting both together: of expected proﬁt,
accounting for l l PV= ‘9 +—(1—5)He +...
1+rr (1+rt)(1+ nil) 3. costbeneﬁt analysis
 is the ? o comparing price of machine measured in terms of
(real cost) with the present value of
(real beneﬁt) How does this generalize to the overall level of investment in an economy?
_ It :
 positive relationship between and of
 similar to how : recall that dividends come from expectations of ﬁrms“ proﬁts Relationship btw investment and the stock market
 suppose K = and shares of stock =
 price per share = $ , price per machine = $
 what should ﬁrms do?  ﬁrms:
0 should of stock (each share generate $ )
o invest in (each unit of K costs $ )  James Tobin: there should be a between stock prices and investment levels does not require calculations of 0 stock prices do the same —> tells ﬁrm how much the public  ﬁrm’s role: compare price of of
capital with public’s willingness to
 stock prices is the public’s assessment of the ﬁrm’s success 0 high mkt price —> investors willing to invest I ﬁrm has
0 high prices also mean
I positive relationship btw
 to prove validity of this relationship:
0 plotted. (variable ), compared it to o closely matched
value of one—unit of K known as
 Tobin’s q constructed by: o ﬁnding (price of share X
number of shares)
0 ﬁnd the total value of (another form of raising
)
0 add value of stock and value of "bonds:
0 divide by the ( cost) 0 outcome: value of a unit of capital installed relative to its current purchase price
 the , the higher the value of capital relative to how
much it costs oq>1—) o magnitude of Tobin’s q indicates
should occur o from example, Tobin’s q is: = [$ >< ]/$  interesting note: the data between and
match up best when using:
0 — tells you whether or not to invest
o — tells us how much was invested
0 supports earlier assumption that investments take time to
be built and installed before in the
next period
 neat, but not altogether surprising:
0 investment decisions and stock prices
0 depend on expected , expected Special Case
 intuitive relationship btw , , and
 suppose ﬁxed over time
 simpliﬁes the earlier expression:  present value of profits is dependent on r (discounting future
payments) and 8 (accounts for decreasing K stock)
 replacing the previous investment function: ...
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 Spring '11
 Wolfson

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