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Macroeconomics ECO 403

LESSON 42

INVESTMENT (Continued...)

The Stock Market and Tobin's q

· The term stock refers to the shares in the ownership of corporations

· Stock market is the market in which these shares are traded.

· The Nobel-Prize-winning economist James Tobin proposed that firms base their

investment decisions on the following ratio, which is now called Tobin's q:

Market Value of Installed Capital

Replacement Cost of Installed Capital

The numerator of Tobin's q is the value of the economy's capital as determined by the

stock market. The denominator is the price of capital as if it were purchased today.

Tobin conveyed that net investment should depend on whether q is greater or less than

· If q >1, then firms can raise the value of their stock by increasing capital,

· if q < 1, the stock market values capital at less than its replacement cost and

thus, firms will not replace their capital stock as it wears out.

Tobin's q and neo-classical model are closely related, since Tobin's q measures the

expected future profitability as well as the current profitability.

If the MPK exceeds cost of capital, the firms are earning profits on their installed

capital, making rental firms desirable to own, raising market value of stocks of such

firms, implying a high value of q

The Stock market as an Economic Indicator

Although the volatility of stock market can give false signals about the future of economy,

yet one should not ignore the link between the two.

Changes in stock market often reflect changes in GDP. whenever stock market experiences

a substantial decline, we should be ready for an upcoming recession.

Why do stock prices and economic activity tend to fluctuate together?

Tobin's q and AD-AS Model

Suppose there occurs a fall in stock prices. Since replacement cost of capital is stable,

this will result in a fall in Tobin's q, reflecting investors' pessimism about the current or

future profitability of capital.

Some Additional Reasons

A fall in stock prices makes people poorer, depressing their spending, resulting in

reduced aggregate demand

Fall in stock prices reflect bad news about technological progress and economic growth,

resulting in slow expansion of natural rate of output.

Financing Constraints

When a firm wants to invest in new capital, e.g. by building a new factory, it raises the funds

in financial markets by

Obtaining loans from banks

Selling bonds to public

Selling shares in future profits on stock market

Neo classical model assumes that if a firm is willing to pay cost of capital, financial markets

will make the funds available.

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Macroeconomics ECO 403

But sometimes firms face Financing constraints, limiting the amount of funds they can raise

from financial market.

So the amount a firm can spend on new capital goods is limited to the amount it is currently

earning.

For example, a recession reduces employment, rental price of capital and profits. If the firm

expects the recession to be short lived, it will continue investing for long term profitability,

thus having a small effect on Tobin's q.

So the firm that can raise funds in financial markets will face a small effect of recession on

the investment.

While incase of firms facing constraints, the fall in current profits restrict the spending on

new capital goods and may prevent such firms from making profitable investment.

Residential Investment

We will now consider the determinants of residential investment by looking at a simple model

of the housing market. Residential investment includes the purchase of new housing both by

people who plan to live in it themselves and by landlords who plan to rent it to others.

To keep things simple, we shall assume that all housing is owner-occupied.

There are two parts to the model:

1) The market for the existing stock of houses determines the equilibrium housing price

2) The housing price determines the flow of residential investment.

The relative price of housing adjusts to equilibrate supply and demand for the existing stock

of housing capital.

Construction firms buy materials and hire labor to build the houses and then sell them at

market price.

Their costs depend on the overall price level P while their revenue depends on the price of

houses PH.

The Higher the PH, the greater incentive to build house.

Market for Housing

Supply of New Housing

PH/P

Relative

Price

of housing

PH/P

Stock of housing capital, KH

Flow of residential investment, IH

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Macroeconomics ECO 403

This model of residential investment is much similar to q theory of business fixed

investment, which states that business fixed investment depends on the market price of

installed capital relative to its replacement cost, which in turn depends on expected profits

from owning installed capital

The residential investment depends on the relative price of housing, which in turn depends

on demand for housing, depending on the imputed rent that individuals expect to receive

from their housing

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