Investment Theory

Materials¶

• Slides: Investment Theory

Notebooks¶

The following computational notebook accompanies the source chapters in the Reading Assignment below:

• Investment Theory: The Marginal q Model: Companion to The Abel-Hayashi Model and An Entrepreneur’s Problem Under Perfect Foresight

Learning Objectives¶

By the end of this lecture, students will be able to:

1. Explain why investment fluctuations account for a disproportionate share of business-cycle variation in GDP

2. Derive the neoclassical cost of capital and the Hall-Jorgenson optimal capital condition

3. Define Tobin’s $Q$ and derive the investment rule it implies

4. Set up the firm’s dynamic optimization problem in the Abel-Hayashi marginal $q$ model and derive the Euler equation for investment

5. State Hayashi’s theorem relating marginal $q$ to average $Q$ and explain why it requires perfect capital markets

6. Describe how capital market imperfections generate investment-cash flow sensitivity, and why this challenges the $q$ model

Key Concepts¶

• Cost of capital: the rental rate that makes a firm indifferent between renting and buying capital; combines the interest rate, depreciation, and tax treatment

• Tobin’s $Q$: ratio of a firm’s stock market value to the replacement cost of its capital; signals whether the firm should expand ($Q > 1$) or contract ($Q < 1$)

• Marginal $q$: shadow price of capital in the firm’s dynamic problem; equals average $Q$ under perfect capital markets (Hayashi’s theorem)

• Adjustment costs: convex costs of changing the capital stock that smooth investment and break the instantaneous adjustment assumption of Hall-Jorgenson

• Investment tax credit (ITC): a direct subsidy to investment that lowers the effective price of capital

• Capital market imperfections: wedge between the cost of internal and external funds; breaks Hayashi’s theorem and generates investment-cash flow sensitivity

Reading Assignment¶

Homework¶