Custom Search
(Trying to really write in note form this
time)
This
question basically asks weather the MEC curve is more likely to hold and thus
determines investment when interest rates change, or is the MEC curve so
unstable that in reality there is not a proper one, so that other factors
determine the investment level. Empirically it has been found that both factors
have an influence, but they are not the only factors that have an effect n the
investment. Investment is also very largely affected by business expectations
about the future. They can think that the business cycle will affect their
demand, or they can expect the future interest rates to be different from the
present rates. Anyway, in order to make a completely subjective assessment
about the relative importance of MEC and about the relative importance of
economic activity in affecting the investment, I must first talk about them
first.
MEC
is the marginal efficiency of capital. Keynes used the term first. Marginal
means the last unit. So marginal efficiency of capital is the amount the last
unit brings in to the firm. It is calculated by taking the net present value of
the extra investment. That is done by summing all the income over years that
this last unit of investment brings. But there is also an opportunity cost
associated with investing this capital - the interest (we assume that there is
only one interest rate) foregone. So we cannot just sum the income this
investment brings, we have to discount it to present value. If interest rate is
10% then 100 quid will be 110 next year. Inversely, if the investment will
bring in 110 pounds next year, with interest 10%, then these 110 pounds is only
worth 100 pounds this year(100 pounds this year could be invested this year to
yield 110 pounds). So firms will discount their income stream, they assume
interest will not change, and use the compound interest rate formulae to
calculate the present value of the future profits:
i=n
((income at time i)/(1+r)i) = present value
i=1
r - interest
rate, assumed that machine is worthless after n time periods. If it could be
sold after n periods at price p then the formula is
i=n
present
value = ((income at time i)/(1+r)i) + p
i=1
The
investment will go ahead if the present value is greater than the cost of
investment. Keynes assumed of diminishing returns. That means as more
investment is made the less profitable the extra investment becomes. Firms will
invest as long as it is profitable for them - as long as the last unit of
investment is profitable, or its present value is just equal to its cost (so
that normal profits are earned). If interest rate falls it is seen from the
formulae that the present value will rise with the future income remaining
constant. So more investment becomes profitable. Keynes took the accountants'
view. He said that as investment rises it will be less profitable, because of
two reasons. First the product you are investing in has a downward sloping
demand curve, as more is produced price must be lowered in order to sell it and
thus marginal revenue of producing last units decreases. Another reason is that
the price of capital is bid up when more investment occurs and thus it becomes
more expensive to invest.
We
can depict the MEC curve now. It is the inverse relationship between investment
and interest rate:
Keynes
did do a small mistake here. Capital usually denotes the whole capital stock,
whereas Keynes here is talking about the flow of capital, that is called
investment.
According
to this graph as interest falls more investment is made and vice versa.
But
investment decisions are rarely marginal. I.e, firms cannot say that the
last 100 pounds of a 10000 pounds' investment they cannot think this brings in
7%, they are more likely to think it will bring between 5-10%. So once they
have thought they will not go for it with 5% interest they will not invest with
6% either. Here is the other weakness. In real life the
base interest rate is changed by the bank only by a small amount, perhaps
0.25%. This will not affect investment much. There is also not only a single
interest rate but several and it depends on the availability of credit whether
a firm can get a loan with the lower interest rate.
Firms'
expectations of the future r will also change, so we cannot just keep the r
constant over time. Keynes called this the animal spirits of investors. This
will shift the MEC curve. There are also problems with capital gains and bonds
(bonds value will increase if rates fall and that might affect firms'
investment decisions). This MEC curve only talks about the desirable stock of
capital (i.e. total investment done over time). It does not explain the speed
of investment, this is discussed in the next point of the essay.
As a
conclusion the rate of investment affects more the money flows in and out of
the economy, not the real investment as the rate changes are only marginal.
Now
about the economic activity level. This view says that as the level of aggregate
demand rises, assuming the constant optimal capital to labour ratio, firm will
need more capital suddenly. But the capital stock is much greater usually than
the amount that depreciates, thus the stock is much grater than the flow of
normal investment taking place all the time. Furthermore, capital brings
returns over time, and it is thus most of time more expensive to build than the
returns on its first time period. So basically because of all this, when the
demand for capital increases by 10%, because aggregate demand has risen by 10%,
investment must rise much more than 10% to produce that extra 10% of capital.
It is assumed that if one invests more, then it becomes more
expensive (shortage of raw material, people working overtime to install the
machinery and to make up the output lost while the factories were not working
due to installing of new machines) (Jugend). Firms would like to invest all this
10% of capital immediately in order to produce optimally, but as this is
expensive they instead use more labour intensive producing methods in the short
run and will raise their investment less sharply (distributed lags). This
is the same thing as accelerator model (it says investment depends on the level
of change in GDP not the absolute
level).
This
model also explain the cyclical nature of the economic growth, because when
aggregate demand (AD) rises and extra investment occurs this will create
(through the multiplier effect) extra artificial increase in the AD which would
stimulate investment even further, so the economy overshoots in investment and
has too much capital to be effective. So it has to get rid of some. But it
cannot just scrap it - it can only stop all investment to new capital, and let
its capital to depreciate. This stop in investment will again have a multiplier
decreasing effect on demand. But the firms will have increased stock during the
period they had too much capacity, they have to sell this stock. So producing
capacity falls to low, because firms will be selling off their stock and do not
want to start the investment too early.
So it
seems to me, without any empirical evidence, that accelerator model does not
have any major criticism, only modifying factors like the firms learning from
experience (rational expectations), whereas there are severe doubts about MEC
model.
Accelerator
model is the same as the model by which private investment depends upon the
level of economic activity discussed in previous section. Q theory is the newer
theory developed by Tobin. It basically says the investment depends on the
difference between the value of the firm when sold and the value of the firm in
the stock market - the more does the stock market value the firm the higher its
investment. These theories are not mutually exclusive, they overlap, but they
are not exclusively the same thing. Q theory is not meant for solely predicting
investment. Investment can be empirically tested in Q model only if a number of
restrictive assumptions are made. On the other hand if Q theory holds it should
explain 100% of investment movements, but there is significant correlation
between the growth of output and the investment as well (supporting the
accelerator view).
So in order to find out whether the q theory
is better is explaining the overlapping areas, I must first give a summary of
the theory, based on Hayashi and Tobin.
As I
said Q=firm value in the City/firm’s asset values. So the investment will
depend on the value of firms' capital, but also on the City’s attitudes, risk
spreading etc. Classical dichotomy does not work quite with the Q theory as
investment decisions are not based on interest rates and this theory implies a
strong link between real IS and monetary LM sectors of the economy.
Older
versions of Q theory said that each asset has its own Q, because financial
assets were imperfect substitutes. Valuation of physical assets relative to
replacement costs will also change. Newer versions have concentrated on the
question why are arbitrageurs not eliminating all the imperfections from the
returns of physical and financial assets. Solution is that it takes time to
replace physical assets and it requires costs - adjustment costs(AC). They are
square function of investment - they rise relative to investment, because as
more investment is undertaken more machines have to be temporarily stopped and
it is harder to train the labour to use them.
AC~I2/K
That
also says that adjustment costs are decreasing as the existing capital stock
increases, because of the economies of scale and availability of cheaper credit
etc. Abel and Lucas have put together an optimising equation for the Q theory
derived from the Eulers optimisation:
I/K~expected
income from the extra investment/purchase price of investment goods(p).
Here
it is clearly seen that the adjustment costs and the optimising output are
different and that gives rise to distributed lags.
The
expected income is the income entrepreneurs expect to receive from the
investment defaulted to the present value. It is very hard to find in the
reality. Writers have found that if one makes assumptions about the market,
namely that is perfect; that all capital is homogeneous and that capital
depreciates geometrically then the right hand side of the last equation is Q.
If we define the value of the firm (V) = expected income from the capital x
capital, then Q=V/pK and I/K=Q
This
result is quite important, despite the fact that the empirical studies do not
support it very well. Q follows from the optimisation process, unlike the
neo-classical model, it does take expectations into account (by using stock
market data) and it is also a very intuitive result, already suggested by
Keynes. Basically it says there is no point in investing if the assets are
worth more separately then the firm in the stock market, or conversely,
enormous investments are made if they can be floated in the stock market
easily.
However,
besides the poor empirical evidence, the adjustment costs are also unreasonably
high, as is suggested by empirical studies. But the main reason why the
empirical evidence is poor is that the firm’s intangible assets are not taken
into account. There is no way to do that at present.
Q
theory is more important in the microeconomics level in determining the
investment. However there is significant correlation between the investment and
the growth rate of the economy, so the accelerator theory is not redundant.
My
own view. Let us look at the difference between the stock market value and the
real value of the firms' assets. This difference is mainly made up of two
things: the expected rise in profits of the firm and its intangible assets.
Very few firms have negative intangible assets (i.e. very bad reputation), but
their profits can be expected to rise. There is a very complicated theory that
predicts the future profits. If these predictions are used one can calculate
the intangible assets of the firm. If we add that to the tangible assets we
should get much higher empirical evidence in investment and Q relation, because
for sure Microsoft is much more willing to advertise and invest on other things
than Cambridge computers, meanwhile the real values of the two firms are not
that different for sure!
The
concerns about the capital shortage have come because the capacity utilisation
in the UK has exceeded 90% sometimes. At the same time the UK still has a high
unemployment. The rate of investment has also been depressed in the UK for last
10 years, as Bean claims.
So
some people fear that in the event of recovery there is not enough capital to
absorb the unemployed and raise national income. Instead inflation will occur
and balance of trade will go into the red. Bean calls this the capital gap and
suggests that investment needs to rise by about 20% compared to 80's level, in
the event of recovery.
However
the pre-war USA experience suggests that the investment can rise rapidly when
it is profitable, so there is no market failure. 20% rise would only represent
the return to 70's investment level. There is only a possible problem in the
short run, but then firms can go to more labour intensive production levels.
Furthermore,
the labour market adjustment is like to take much more time than the increase
investment. The trade unions are slow to change their policies. AT the present
England has the insider-outsider problem - many long-term unemployed have accepted
outsider view and do not search for the job actively. So it takes longer time
to recruit and train the extra people that it does to increase investment. So
England is unlikely to have a capital shortage at present, it is more likely to
be using the most cost effective ways of production when it has utilised the
capital to 90%.