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EC111LectNG13

# EC111LectNG13 - EC111 MACROECONOMICS Spring term 2012...

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1 EC111 MACROECONOMICS Spring term 2012 Lecturer: Jonathan Halket Week 18 Investment and the IS curve So far we have taken investment as given; it fluctuates for reasons outside of our model. Investment is one of the most volatile components of national expenditure. Investment is a forward-looking decision. Firms invest in anticipation of future profits that flow from e.g. the use of a machine. A simple rule is to invest when the benefits to the firm of making the investment exceed the cost. But the costs must be incurred now and the returns from the investment accrue in the future. We can compare the future returns with the present costs by discounting the returns back to the present. If the interest rate is ten percent (r = 0.1) then £100 invested today will yield £100 (1 + r) = £110 in one year’s time, or £110 (1 + r) = £100 (1 + r) 2 = £121 in two year’s time. So £110 after one year is ‘worth’ = £100 now, and £121 in two years is equivalent to = £100. In general the present value of £X in n years time is: . The present value of a stream of profits is from an investment project is: Where π 1 is profits for the first year and π n is the firm’s profit for the last year (assume the machine falls apart and has no scrap value thereafter). The net present value is the PV of future returns minus the current cost, call it J o .

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2 An example: A firm has two potential investment projects, A and B. Both have the same initial cost J 0 = £180. Year 1 Year 2 PV; r = 0.1 PV; r = 0.2 Project A 200 175 Project B 200 183 With the interest rate at 10 percent both projects are worth undertaking, as the NPV is positive (200 180). With r = 20 percent, only project, B, has a positive net present value. Note that: The project with the most distant returns (A) has to yield a larger absolute amount, 231, as compared with 220. The NPV of the project with more distant returns is more sensitive to r. The same calculation applies whether the firm borrows the money to pay for the investment or uses its own funds. As long as the firm can borrow or lend at interest rate r, the opportunity cost to the firm is the same. Question: why is this? If there was some scrap or resale value to the machine at the end of its life, this would be added to the last period’s profit. For each firm, the lower is the interest rate the more potential investment projects become profitable. In the economy as a whole we can think of firm’s together facing an array of possible investments (new possibilities come along each period). The higher is the interest rate, the less investment will be undertaken in aggregate. The economy-wide investment schedule is the Marginal Efficiency of Investment Schedule (MEI). Note: this is related to the factor demand curve for capital; this is for increments to capital plus investment to cover depreciation (i.e. it is gross investment). The ‘price’ here is the interest rate, but J 0 will also reflect the price of capital goods.
3 Recall that investment decisions depend on expectations of future profit. These expected profits change as new information emerges or firms’ optimism about fu ture prospects changes. These will shift the MEI up or down (change in h).

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EC111LectNG13 - EC111 MACROECONOMICS Spring term 2012...

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