Investment and the Stock Market

Many economists see a link between fluctuations in investment and

fluctuations in the stock market. Economic theory suggests that rises
and falls in the stock market should lead firms to change their rates of
capital investment in the same direction: Firms change investment in
the same direction as the stock market.
The relationship between stock prices and firms investment in
physical capital is captured by the q theory of investment, called
Tobins q, developed by James Tobin.

Investment and the Stock Market

5.11 : =

where is stock market value of firm (the value of the economys

capital as determined by the stock market = stock price x the number
of shares), is firms capital and is price of new capital.
The denominator is the price of that capital if it were purchased
today.
Tobin reasoned that net investment should depend on whether q is
greater or less than 1.

Investment and the Stock Market

> 1
>
Managers can raise the market value of firms stock by buying
more capital. Invest more!
< 1
<
Managers will not replace capital as it wears out. Dont invest!
Booming stock market raises V, causing q to rise, increasing
investment.

Figure 5.5: Investment and Tobins q, 1987 - 2012

Investment and the Stock Market

Tobins q and real private non-residential investment are closely
related; they rose together throughout the 1990s and then both fell
sharply in 2000 and 2008. But the relationship isnt strong in the 1987
stock market crash and the mid-2000s because many other things
change at the same time.
Relationship b/w the q theory of investment and neoclassical theory
of investment:
Higher
Higher future earnings
Increases V and so q.

Investment and the Stock Market

Relationship b/w the q theory of investment and neoclassical theory
of investment:
A falling real interest rate
raise stock prices and hence q as investors substitute away from
low-yielding bonds and bank deposits and buy stocks instead.
A decrease in the purchase price of capital
Lower replacement cost of installed capital
Raise q.
Because all three types of change increase Tobins q, they also
increase the optimal capital stock and investment.

Investment and the Stock Market

Q: What is the advantage of Tobins q as a measure of the incentive to
invest?
A: Tobins reflects the expected future profitability of capital as well
as the current profitability. For example, Congress legislates
a reduction in the corporate income tax beginning next year
Greater profits for the owners of capital
Higher expected profits raise the value of stock today
Increase Tobins q
Raise investment today.

Investment and the Stock Market

Tobins q theory of investment emphasizes that investment decisions
depend not only on current economic policies but also on policies
expected to prevail in the future.

Investment and the Stock Market

Q: Does the stock market work as an economic indicator?
A: Paul Samuelson says The stock market has predicted nine out of
the last five recessions. According to Paul Samuelsons famous quip,
the stock market is reliable as an economic indicator, but it is in fact
quite volatile, and it can give false signal about the future of the
economy. Yet we should not ignore the link between the stock market
and the economy.

Figure 5.6: The stock market and the economy

Investment and the Stock Market

Q: Why do stock prices and economic activity tend to fluctuate
together?
A: (i) Tobins theory
For instance, suppose that you observe a fall in the stock prices.
Because the replacement cost of capital is fairly stable, a fall in the
stock market is usually associated with a fall in Tobins q. A fall in
Tobins q reflects investors pessimism about the current and future
profitability of capital, meaning that the investment function shifts
inward: investment is lower at any given interest rate. As a result,
the AD for goods and services contracts, leading to lower output and
employment.

Investment and the Stock Market

(ii) Because stock is part of household wealth, a fall in stock prices
makes people poorer and thus depresses consumer spending, which
also reduces AD.
(iii) A fall in stock prices might reflect bad news about technological
progress and long-run economic growth. If so, this means that the
natural level of output and thus AS will be growing more slowly in
the future than it was previously expected.

Investment and the Stock Market

The stock market is a closely watched economic indicator. A case in
point is the deep economic downturn in 2008 and 2009:
the substantial declines in production and employment coincided
with a steep decline in stock prices.

Inventory Investment
Inventory investment (the goods that businesses put aside in storage)
is negligible and of great significance. It is one of the smallest
components of spending, averaging 1 percent of GDP. Yet its
remarkable volatility makes it central to the study of economic
fluctuations. In a typical recession, more than half the fall in spending
comes from a decline in inventory investment.
Q: Why do businesses hold inventories?
A: Inventories serve many purposes.

Inventory Investment
(i) Production smoothing
One use of inventories is to smooth the level of production over time.
When a firm experiences temporary booms and busts in sales, it may
find it cheaper to produce goods at a steady rate rather than
adjusting production to match the fluctuations in sales. When sales
are low, the firm produces more than it sells and puts the extra goods
into inventory. When sales are high, the firm produces less than it
sells and takes goods out of inventory.

Inventory Investment
(ii) Inventories as a factor of production: the larger the stock of
inventories a firm holds, the more output it can produce.
Inventories may allow a firm to operate more efficiently.
For example, manufacturing firms keep inventories of spare parts to
reduce the time that the assembly line is shut down when a machine
breaks.
(iii) Stock-out avoidance: avoid running out of goods when sales are
unexpectedly high.
If demand exceeds production and there are no inventories, the good
will be out of stock for a period, and the firm will lose sales and profit.
Inventories can prevent this from happening.

Inventory Investment
(iv) Work-in-process
Many goods require a number of production steps and, therefore,
take time to produce. When a product is only partly completed, its
components are counted as part of a firms inventory.

Inventory Investment
Q: How do the real interest rate and credit conditions affect inventory
investment?
A: (i) Inventory investment depends on the real interest rate.
When a firm holds a good inventory and sells it tomorrow rather than
selling it today, it gives up the interest it could have earned between
today and tomorrow. Thus, the real interest rate measures the
opportunity cost of holding inventories. When the real interest rate
rises, holding inventories becomes more costly, so rational firms try
to reduce their stock.

Inventory Investment
Therefore, an increase in the real interest rate depresses inventory
investment. For example, in the 1980s many firms adopted just-in time production plans, which were designed to reduce the amount
of inventory by producing goods just before sale.
(ii) Inventory investment also depends on credit conditions. Because
many firms rely on bank loans to finance their purchases of
inventories, they cut back when these loans are hard to come by.

Inventory Investment
For instance, during the financial crisis of 2008 2009, firms reduced
their inventory holdings substantially. During this severe recession, as
in many economic downturns, the decline in inventory investment
was a key part of the decline in AD.

The Goods Market and the IS Relation

Summary of the Goods Market:
production demand , called the IS relation
= + + + ,
where I, G, TR and T were taken as given.
We considered the factors that moved equilibrium output; we looked
at the effects of changes in G and of shifts in consumption demand.
The main simplification of this first model was that the interest rate
did not affect demand for goods. Our first task in this note is to
abandon this simplification and introduce the interest rate in the
model of equilibrium in the goods market.

Investment (I)
5.12 : = , = + where 0 , 1 , 2 > 0.
+

Y = the level of sales = production, assuming that inventory

investment is zero,
i = the (nominal) interest rate,
1 measures the responsiveness of investment spending to income,
2 measures the responsiveness of investment spending to the
interest rate,
and 0 denotes autonomous investment spending that is
independent of both income and the interest rate.

Investment (I)
5.12 : = , or = 0 + 1 2
+,

The higher the interest rate, the less attractive a firm is to borrow and
invest since the interest rate is the cost of borrowing to finance
investment projects. At a high enough interest rate, the additional
profits from using the new machine will not cover interest payment
and the new machine will not be worth buying.

Investment (I)
5.12 : = , or = 0 + 1 2
+,

Q: What determines the position of the investment curve?

A: The position of the investment curve is determined by the slope
and by the level of autonomous investment spending .
If investment is highly responsive - 2 is large to the interest rate,
a small decline in interest rates will lead to a large increase in
investment, so the investment curve is almost flat.
Conversely, if investment responds little to interest rate,
the investment curve will be relatively steep.

Investment (I)
Changes in autonomous investment spending 0 shift the
investment line.
An increase in 0 means that at each level of the interest rate, firms
plan to invest at a higher rate. This means a rightward shift of the
investment line.

Determination of Output
5.13 : = = + + , +
income and so
.
In short, ( ) through its effect on both consumption
and investment.
This relation between demand and output, for a given interest rate,
is represented by the upward-sloping curve ZZ.

Deriving the IS Curve

The initial equilibrium is at point A.



The demand curve shifts down to : At a given level of
output, demand is lower.
The new equilibrium is at point .
The equilibrium level of output is now equal to 2 .

Deriving the IS Curve

In words: The increase in the interest rate decreases investment.
The decrease in investment leads to a decrease in output, which
further decreases consumption and investment, through the
multiplier effect.
In essence, the IS curve combines the interaction between ( )
and expressed by the investment function and the interaction
between and demonstrated by the Keynesian cross.

Figure 5.6: The Derivation of IS Curve

The IS Curve
The IS curve shows the combination of the interest rate and
the equilibrium level of income in the goods market.
An increase (a decrease) in i leads to a fall (or a rise) in Y: IS curve is
downward sloping i and the equilibrium output (Y) is negatively
related. That is, the IS curve illustrates how the equilibrium level of
income depends on the interest rate.
The IS curve shows for any given interest rate the level of income that
brings the goods market into equilibrium.
Keep in mind that each point on the IS curve represents the
equilibrium output in the goods market for the given interest rate.

The IS Curve

Q: Why does the IS curve slope downward?

A: Because an increase in the interest rate causes investment to fall,
which in turn causes equilibrium income to fall, the IS curve slopes
downward.

Mathematical Derivation of the IS Curve

=
= + +
= 0 + 1 + + 0 + 1 2 +
1 1 1 = 0 + 0 + 1 + 2
1 1 1 1 = 0 + 0 + 1 + 2
5.14 : =

1
11 1 1

0 + 0 + 1 +

11 1 1

1
1 1 1 1
5.14 : =
0 + 0 + 1 +

2
2
Meaning: The IS curve gives all the combination of and that cause
the market for goods to clear (i.e. to be in equilibrium).