Business 33001: Microeconomics

Transcription

1 Business 33001: Microeconomics Owen Zidar University of Chicago Booth School of Business Week 6 Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 1 / 80

2 Today s Class 1 Preliminaries Real Interest Rates Present Value 2 Capital Markets Definitions 4 key building blocks Analytical Framework Analysis of Changes Applications: capital taxes, housing bubble, interest rate cuts, etc. 3 Investment Benefits: price of output MPK Costs Policy in the financial crisis: Bail out banks vs Investment Tax Credits Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 2 / 80

3 Motivation: why should you care? 1 Build a useful framework for capital markets Link real economy and asset prices Evaluate investment decisions 2 Applications Was the housing crisis a bubble or could it have been perfectly rational? Evaluate when housing markets will recover Determine how much asset prices will respond to changes in the real economy 3 Build a useful framework for investment Key drivers of investment Consider why investment dropped in Evaluate policy responses: bailing out banks and investment tax policy Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 3 / 80

4 Big Picture: Part 1 We will use 4 intuitive building blocks to analyze capital markets 1 Stock Adjustment: the amount of capital today depends on how much there was yesterday, depreciation, and new investment 2 Asset pricing equilibrium: 1 the rental price of using an asset is simply the cost of buying the good and re-selling it after one period 3 Rental market equilibrium: the demand for using capital services is downward sloping 4 Investment market equilibrium: the supply of capital assets is upward sloping 1 Equivalently, the price of an asset is the present discounted value of cash flows from renting it in perpetuity. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 4 / 80

5 Big Picture: Part 2 Use the link between rental and asset markets to analyze capital markets Rental Market Asset Market R t P t S(R t ) S(P t ) R* P* D(R t ) D(P t ) K* K t I* I t where R t is the rental price of using capital services K t and P t is the purchase price, which depends on the level of investment I t. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 5 / 80

6 Preliminary Concepts Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 6 / 80

7 Choices over time We have been focusing on prices of different goods at a point in time Can also think about price of a given good at different points in time Interest rates are a convenient way of expressing these prices What is an interest rate? Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 7 / 80

8 Interest Rates Nominal interest rate r: I give you a dollar today, put it in the bank, and get 1 + r dollars tomorrow Real interest rate r is in terms of goods instead of in terms of dollars How do we get r on apples? How many apples can I get next period for an apple today? Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 8 / 80

9 Real Interest Rates The question is how would I turn an apple today into an apple next period? We can use the bank Let s sell the apple today at price P A t Take that money and put it in bank. They will give me 1 + r for every dollar today Use the proceeds to buy apples next period at price P Apples t+1 Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 9 / 80

10 Example: Real Interest Rate for Apples 1 + r = PA t (1 + r) P A t+1 Pt A (1 + r) is how many dollars I get back from the bank Scale by price of apples Pt+1 A to get the number of apples tomorrow Can also think about this in terms of the inflation rate of apples π A 1 + r = (1 + r) P A t+1 /PA t = 1 + r 1 + π A Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 10 / 80

11 Real Interest Rates In the market, there will be many real rates (e.g. other goods besides apples) Need to be careful in practice in terms of having different inflation for different goods Have to be careful about putting things in terms of real rate Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 11 / 80

12 Present Values Present value tells you how much this flow of income worth today Say your sales associates tells you that the company will make $100 in revenue this year and $200 next year What do I multiply the $200 by? Is this a real rate or a nominal rate? Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 12 / 80

13 Capital Markets Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 13 / 80

14 Capital Markets 1 Definitions Durable goods Depreciation 2 4 Building Blocks 3 Analytical Framework 4 Comparative statics, Analysis, and Applications Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 14 / 80

15 Capital goods Capital assets are durable. They produce a flow of services in more than one period How long such goods last can be measured by their depreciation rate δ, i.e., what fraction of the good is lost after one period of use Examples: capital equipment, housing, cars, people (human capital), etc. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 15 / 80

16 Depreciation If we have 100 units of the good today, we will have 100(1 δ) tomorrow Depreciation can be imagined in two ways: as a house burning to the ground or as an iceberg slowly melting It is calculated by comparing the value of a year-old and a new unit of the good in the same period: 1 δ = POne year old t P new t Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 16 / 80

17 Capital goods: there are two prices and two quantities For durable goods, we must make distinctions for both the Q and P Quantity 1 K is the stock of the capital good, i.e., how much is available at a given point in time 2 I is the new production of the good, which is often called gross investment Price 1 R is the rental price, i.e., what it costs to use the good for one period 2 P is the purchase price, i.e., what it costs to buy the good Key point: It is critical to recognize that these prices are economic concepts. The are defined and relevant even if there only exists a purchase market in practice (i.e. whether people buy or rent) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 17 / 80

18 4 Building Blocks 1 Stock Adjustment: K t = (1 δ)k t 1 + I t 2 Asset pricing equilibrium The rental cost of using an asset is simply the cost of buying the good and re-selling it after one period 3 Rental market equilibrium: K = D(R) 4 Investment market equilibrium: I = S(P) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 18 / 80

19 2. Asset pricing equilibrium What is the relationship between rental and capital prices? The rental cost of using an asset is simply the cost of buying the good and re-selling it after one period R t = P t (1 δ)p t r r is the nominal rate of interest P t+1 is next year s price for the good Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 19 / 80

20 2. Asset pricing equilibrium: Housing example Suppose Suppose r =.10 and δ = 0 P t+1 =$ 110 K P t =$ 100 K What is R t? R t = P t (1 δ)p t r R t = R t = 0 Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 20 / 80

21 2. Analyzing Rental Price: Housing example Recall that the rental price of using an asset is simply the cost of buying the good and re-selling it after one period Even if I can t afford to live in an expensive home, the implied rental rates will be low, which makes the demand for using these houses high Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 21 / 80

22 2. Analyzing Rental Price We can rearrange the expression to show rental prices depend on three things: R t = rp t + δp t+1 + P t P t r 1 Interest cost 2 : rp t 2 Depreciation: δp t+1 3 Market re-evaluation: P t P t+1 Rental prices are higher, the higher is r, the greater is the physical rate of depreciation, and the faster the price of the asset is declining 2 Think of as opp. cost. If you pay $1M to get an asset, the opp. cost is r $1M. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 22 / 80

23 2. Analyzing Rental Price: Car example R t = rp t + δp t+1 + P t P t r If cars lose their value quickly (i.e., P t >> P t+1 ), then rental prices will be pretty high What would happen to computer sales if technology stopped advancing? Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 23 / 80

24 2. Analyzing Capital Prices We can also use the rental price expression to calculate the implied capital price P t = R t + R t+1(1 δ) (1 + r) + R t+2(1 δ) 2 (1 + r) This equation can be obtained by recursively substituting for future prices in the rental price equation This equation should look familiar to you (prices are PV of cash flow stream) Capital prices are higher when rental payments to the owner are large and soon Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 24 / 80

25 4 Building Blocks 1 Stock Adjustment: K t = (1 δ)k t 1 + I t 2 Asset pricing equilibrium R t = P t (1 δ)p t+1 1+r 3 Rental market equilibrium: K = D(R) 4 Investment market equilibrium: I = S(P) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 25 / 80

26 3. Rental Market Equilibrium for Housing Services K t = D(R t ) The demand for housing services depends on the flow cost of housing services (i.e., the rental rate R t ). R t is what I pay to use the asset Housing services are provided by the stock of housing K t The demand side of the market links the current rental price and the current stock Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 26 / 80

27 3. Rental Market Equilibrium Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 27 / 80

28 4. Investment Market Equilibrium I t = S(P t ) The supply of new construction, investment depends on its current price Think of this as a new car producer who decides how much to supply based on the current price Alternatively, housing construction firms see high house prices and build. They build more when prices are high. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 28 / 80

29 4. Investment Market Equilibrium Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 29 / 80

30 4 Building Blocks K t = (1 δ)k t 1 + I t (1) R t = P t (1 δ)p t r (2) K t = D(R t ) (3) I t = I (P t ) (4) 4 equations and 4 unknowns, but depends on past and the future. Where do past and future come in? Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 30 / 80

31 Market Equilibrium: Past and Future in Housing When we look at a market equilibrium for the housing market at any one point in time, we must realize that today s market is influenced by both the past and future The effect of the past comes through the effect of past production decisions on the stock of housing The effect of the future comes from the effect of future expected rental rates on the current price Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 31 / 80

32 What does the system look like in steady state? K = (1 δ) K + Ī (1 δ) P R = P 1 + r K = D( R) Ī = S( P) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 32 / 80

33 What does the system look like in steady state? Ī = δ K R = P ( 1 K = D( R) Ī = S( P) ) (1 δ) 1 + r Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 33 / 80

34 What does the system look like in steady state? We can use the first two equations to plug into the second two equations and obtain the supply and demand in the use market. ( R 1 (1 δ) 1+r Ī }{{} δ K Ī = δ K ) = P K = D( R) = S( }{{} P ) ( R 1 (1 δ) ) 1+r Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 34 / 80

35 What does the system look like in steady state? K = D( R) K = 1 δ S ( R 1 (1 δ) 1+r ) This shows that we have a familiar supply and demand diagram where the quantity is K and the price is R Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 35 / 80

36 Capital Market Equilibrium R t S(R t ) R* D(R t ) K* K t Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 36 / 80

37 Example: Glass houses Suppose the demand for houses K(R) is given by K = 100 R Suppose supply of new houses S(P) is given by S = P Suppose further that δ = 1. What does δ = 1 mean intuitively? K = 100 R K = 1 1 S R ( ) = 1 1 (1 1) 1 R 1+r Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 37 / 80

38 Example: Glass houses continued Equating demand and supply yields: 100 R = R R = 50 K = 50 We can use the other two expressions to determine P and Ī : Ī = δ K = 1(50) = 50 R P = ( ) = 50 1 (1 δ) 1 = 50 1+r Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 38 / 80

39 Example: A brick house Suppose the demand for houses K(R) is given by K = 100 R Suppose supply of new houses S(P) is given by S = P Suppose further that δ =.1. What does δ =.1 mean intuitively? Finally, suppose r =.2 K = 100 R K = S R ( 1 (1 0.1) 1+r ) = ( ) ( ) R R 1.9 = 10 = 40 R Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 39 / 80

40 Example: a brick house continued Equating demand and supply yields: 100 R = 40 R R = K = We can use the other two expressions to determine P and Ī : Ī = δ K =.1(97.6) = 9.7 ( ) R 100/41 P = ( ) = 1 (1 δ) 1.9 = r 1.2 Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 40 / 80

41 Example: a 50% in demand Glass House K = 150 R K = R R = 75 K = 75 P = 75 Ī = 75 Investment increases 50% and it would take 1 year of steady state to meet demand K Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 41 / 80

42 Example: a 50% in demand Brick House K = 150 R K = 40 R R = K = P = 150/ Ī = δ K 14.6 Investment increases 50% and it would take 10 years of steady state to meet demand K Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 42 / 80

43 Example: Glass versus brick houses Depreciation is the key difference between nondurables and durables Notice that investment is much smaller than K for durable assets (with low δ). The relative size of capital and asset markets depend crucially on depreciation Implication: A shock to the demand for capital will have much bigger impact on asset markets when depreciation is low. For instance, when δ = 1 20, impact is 20X Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 43 / 80

44 Capital Market Equilibrium: Analysis of Changes 5 Examples: 1 Earthquake that destroys part of capital stock 2 Increase in construction costs 3 Decline in the interest rate 4 Impact of Capital Tax 5 The Great Housing Boom and Bust of the 2000s Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 44 / 80

45 Earthquake Destroys part of capital stock Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 45 / 80

46 Earthquake Destroys part of capital stock The main impact is on the use market. Lower K increases R. Higher rental prices cause the asset price P to increase. However, since rental rates we decline as we rebuild capital stock, the increase in P is smaller than increase in R Investment follows P, so it will jump and slowly decline as we rebuild the stock Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 46 / 80

47 Earthquake Destroys part of capital stock Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 47 / 80

48 Speed of Adjustment What determines the speed of convergence to the steady state? 1 Elasticity of demand in the rental market ε D. For example, the more the rental price goes up following a destruction of the capital stock, the faster we will converge to steady state (since it will make the capital price go up more, and thereby also investments). With a higher elasticity (in absolute value), the rental price will go up more. 2 Elasticity of supply in the investment market ε S. This will make investment go up more when the capital price goes up. 3 The depreciation rate δ. This may be the most important aspect, since it puts a lower bound on the speed of convergence. The slowest rate at which the economy ever can return to the steady state is δ. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 48 / 80

49 Increase the cost of new construction Suppose the economy is in steady state and suddenly the costs of new construction increase. The main impact is on the asset market. Supply curve shifts left. Lower supply decreases new construction The lower stock of capital causes rents to rise Rising rents and the prospects of future higher rents (remember long-run rents are higher) cause the price to rise As prices rise over time, construction rebounds Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 49 / 80

50 Increase the cost of new construction Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 50 / 80

51 Decline in the interest rate Suppose the economy is in steady state and suddenly the interest rate r declines. Lower r future streams of payments are more valuable, so P will jump up The jump in asset prices causes investment to jump up More investment increases the capital stock Higher capital stocks start to decrease rental rates Higher rental rates decrease asset prices We will end at a steady state with higher K and lower R Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 51 / 80

52 Decline in the interest rate Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 52 / 80

53 Impact of a Capital Tax Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 53 / 80

54 Impact of a Capital Tax The real price of capital will be determined in the use market A tax on capital will increase the pre-tax return to capital and decrease the after-tax return The key question is how the capital tax is split between a decline in the after-tax return and a rise in the pre-tax return Short run: supply of capital is likely to be quite inelastic so that a tax on capital will mostly reduce the after-tax rerun with little increase in the pre-tax return Long run: supply of capital is likely very elastic (net returns tend to be about 6 to 7% and independent of level of capital taxes). Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 54 / 80

55 Impact of a Capital Tax Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 55 / 80

56 Impact of a Capital Tax (in Long Run) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 56 / 80

57 Impact of a Capital Tax Who bears the capital tax in the long run? Who gets the triangle above R-pre-tax (i.e., consumer surplus in the typical S and D graph)? If firms don t earn profits, this all goes to workers in terms of higher wages or lower prices Note that the distortion in the capital market reduces surplus more than it increases tax revenues Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 57 / 80

58 US House Prices and Residential Investment Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 58 / 80

59 US House Prices and Residential Investment Was this an irrational bubble? Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 59 / 80

60 US House Prices and Residential Investment What did we see in the housing boom in the 2000s? Low interest rates and high capital prices Therefore, housing services are cheap to use and investment will increase as S(P) increases with P Suppose people expected higher future demand More downward pressure on rental prices, higher capital prices, more construction Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 60 / 80

61 US House Prices and Residential Investment What did we see in the housing bust in the late 2000s? We ve build up a large housing stock Suppose now the anticipated increase in demand never comes Falling house prices Big decline in investment Also makes consuming housing services more expensive Things will adjust as housing stock goes back to the steady state Was this an irrational bubble? Observing a crash in the housing market does not tell us whether (1) there were rational expectations about future demand (coupled with low interest rates) or (2) a bubble (that could not be justified by expectations). Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 61 / 80

62 Investment Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 62 / 80

63 Overview of Investment 1 Factor demand: firms consider benefits (MPK and P) and cost (R) First benefit: marginal product of capital Second benefit: price of output Cost: R from the first part of lecture 2 Example investment problem 3 Policy: evaluating the case for bailing out banks (lowering the cost) vs investment tax credits (which increases the benefit) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 63 / 80

64 Investment has two benefits: MPK and P Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 64 / 80

65 First Benefit: Marginal Product of Capital (MPK) Suppose a firms production function is: F (K) = K α Taking a derivative w.r.t. K gives MPK: MPK = αk α 1 The marginal product of capital tells us how much more output we get for one additional unit of capital Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 65 / 80

66 Benefits increase with productivity (i.e., higher MPK) Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 66 / 80

67 Marginal Product of Capital (MPK) and productivity (A) Suppose the firm production function is: F (K) = AK α Taking a derivative w.r.t. K gives MPK: MPK = αak α 1 The marginal product of capital tells us how much more output we get for one additional unit of capital Higher productivity increases the amount of output an additional unit of capital generates Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 67 / 80

68 Second benefit: prices Suppose a firms production function is: F (K) = K α Revenue is: Marginal revenue w.r.t K is: Revenue = pf (K) = pk α VMPK = p αk α 1 The value of the marginal product of capital (VMPK) tells us the value of additional output we get from one additional unit of capital VMPK tells us the marginal benefit of additional capital Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 68 / 80

69 Marginal benefits and marginal cost will determine K Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 69 / 80

70 Source of financing may affect effective costs Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 70 / 80

71 Investment decisions Overall, there are 2 questions firms ask when making investment decisions: 1 Intensive margin: If I invest, how much should I invest? Set marginal benefits equal to marginal costs to determine K In particular, MB is VMPK and MC is R 2 Extensive margin: Should I invest or not? This decision depends on fixed costs of investment which could be large Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 71 / 80

72 Investment Decision: Example Setup Two periods No fixed cost of investment (to keep things simpler) Firms start with a capital stock K 1 = 100 in first period Firms can invest I in capital goods and have K 2 = (1 δ)k 1 + I in the second period The price of final goods p = 1 Capital goods cost P 1 relative to final goods in first period Capital goods cost P 2 relative to final goods in second period Firms use capital to produce output in both periods Y t = A t K 1 2 t Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 72 / 80

73 Investment Decision: Example continued where π 1 = K P 1 I = 10 P 1 I π 2 = A 2 K P 2 (1 δ)k 2 max K 2 π 1 + π r Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 73 / 80

74 Investment Decision: Example continued We determine K 2 by taking a derivative of PDV of profits: max K P 1 I + A 2K2 + P 2(1 δ)k r To maximize profits, firms invest in capital K 2 up to the point where the future VMPK 2 is equal to the user cost of capital R A 2K } 1 {{ + r } VMPK 2 = P 1 P 2(1 δ) 1 + r }{{} =R 1 VMPK 2 is the value of additional output in period 2 (which is why it is discounted by 1 1+r ). R 1 is the cost of using capital (recall the building block eq # 2) Intuitively, you invest today, and get more output tomorrow. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 74 / 80

75 Investment Decision: Example continued We can now solve for the optimal amount of capital in period 2: 1 2 A 2K = R r ( 1 K2 2 = A 2 R 1 (1 + r) ) 2 This expression shows that optimal capital stock reflects benefits and costs Notice K2 is higher when future productivity is higher is lower when the user cost of capital is high K 2 Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 75 / 80

76 Investment Decision: Example continued We determine I from the expression for K2 adjustment equation and from the stock K 2 = (1 δ)k 1 + I ) 2 = (1 δ)100 + I ( 1 2 A 2 R 1 (1 + r) ( 1 2 A ) 2 2 (1 δ)100 = I R 1 (1 + r) Investment depends on the optimal capital stock in the future and how much of existing capital stock has depreciated Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 76 / 80

77 Dynamics: depreciation reduces capital stock Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 77 / 80

78 Policy: Investment Drop in Real Private Nonresidential Fixed Investment 10 (Percent Change from Year Ago) Source: US. Bureau of Economic Analysis Shaded areas indicate US recessions research.stlouisfed.org Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 78 / 80

79 Policy: Investment Drop in Explanations: 1 Firms expected lower productivity (low MPK) or low demand (low P) in the future and therefore did not invest (demand of loans contracted) 2 Banks suffered severe shocks in balance sheets from mortgages and became unwilling to lend to firms (supply of loans contracted) - think of this as an increase of the effective user cost that firms face Distinguishing between demand and supply matters for designing policies to help economy recover. Should we recapitalize banks to increase supply? Or should we give investment tax credits to stimulate demand? Credit crunch evidence: business loan rates increased sharply relative to the cost of funds (Fed s fund rate). Hence, it was the supply of loans that contracted. But still an open question. Rationing of loans, tougher lending standards and higher loan rates are symptoms of a banking crisis. Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 79 / 80

80 Policy: Business Loan Rate over Fed s Fund Rate Owen Zidar (Chicago Booth) Microeconomics Week 6: Capital & Investment 80 / 80