17Chapter-Mankiw - CHAPTER 17 Investment Questions for...

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Questions for Review 1. In the neoclassical model of business fixed investment, firms will find it profitable to add to their capital stock if the real rental price of capital is greater than the cost of capital. The real rental price depends on the marginal product of capital, whereas the cost of capital depends on the real interest rate, the depreciation rate, and the relative price of capital goods. 2. Tobin’s q is the ratio of the market value of installed capital to its replacement cost. Tobin reasoned that net investment should depend on whether q is greater or less than one. If q is greater than one, then the stock market values installed capital at more than it costs to replace. This creates an incentive to invest, because managers can raise the market value of their firms’ stock by buying more capital. Conversely, if q is less than one, then the stock market values installed capital at less than its replacement cost. In this case, managers will not replace capital as it wears out. This theory provides an alternative way to express the neoclassical model of investment. If the marginal product of capital exceeds the cost of capital, for example, then installed capital earns profits. These profits make the firms desirable to own, which raises the market value of these firms’ stock, implying a high value of q . Hence, Tobin’s q captures the incentive to invest because it reflects the current and expected future profitability of capital. 3. An increase in the interest rate leads to a decrease in residential investment because it reduces housing demand. Many people take out mortgages to purchase their homes, and a rise in the interest rate increases the cost of the loan. Even for people who do not borrow to buy a home, the interest rate measures the opportunity cost of holding their wealth in housing rather than putting it in the bank. Figure 17–1 shows the effect of an increase in the interest rate on residential investment. The higher interest rate shifts the demand curve for housing down, as shown in Figure 17–1(A). This causes the relative price of housing to fall, and as shown in Figure 17–1(B), the lower relative price of housing decreases residential investment. 165 Supply Supply Demand Relative price of housing K H I H Stock of housing Investment in housing P H /P P H /P Figure 17–1 CHAPTER 17 Investment
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4. Reasons why firms might hold inventories include: a. Production smoothing. A firm may hold inventories to smooth the level of produc- tion over time. Rather than adjust production to match fluctuations in sales, it may be cheaper to produce goods at a constant rate. Hence, the firm increases inventories when sales are low and decreases them when sales are high.
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This note was uploaded on 02/22/2012 for the course ECON 602 taught by Professor Smith during the Spring '12 term at FSU.

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17Chapter-Mankiw - CHAPTER 17 Investment Questions for...

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