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Errol D’Souza

Investment
Financial capital is essentially money or some other
Errol D’Souza form of paper asset or security that function
as contracts for the exchange of commodities
or money

Physical capital, on the other hand, is a piece of

productive equipment that is long-lived, such
as a lathe or a Xerox machine that generates
a flow of productive services over time.
Indian Institute of
Advanced Study
Rashtrapati Niwas
Shimla

Turin School
of Development

Email: errol@iimahd.ernet.in

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A striking fact about investment in physical capital is that it

fluctuates much more than consumption.

Gross Fixed Capital Formation in real terms over the period

1991-92 to 2021-22 varied between a minimum of
20.3 per cent of GDP to a maximum of 34.3 per cent
of GDP.

Investment is more volatile than private consumption exp-

enditure.

Whereas households smooth consumption over time firms

cut investment in response to a weakening economy
and raise it promptly when the economy is booming.

Investment then is at the heart of economic growth cycles.

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Figure 4.2: Real Private Consumption Expenditure (INR) and Real

9000000 Gross Fixed Capital Formation (INR)
Investment and consumption grow or contract together ─
a pattern that economists refer to as co-movement 8000000
of economic variables. 7000000
6000000
This means that when consumption growth is high,
investment growth also tends to be high and 5000000
similarly when consumption growth is low 4000000
then investment growth tends to be low. 3000000
2000000
1000000
0

Private Final C Expenditure Gross Fixed Capital Formation

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How much capital should a firm install?
We approach the response to this using the principle of
arbitrage
Alternatively the sum of money could be used to purchase
the unit of capital good.
The capital would be employed to produce an output
over the accounting period

Consider the choice before a baker who is considering the The additional output produced when an additional
option of scaling up and is considering adding an oven to unit of capital input is hired is the marginal
the bakery. product of capital , 𝑀𝑃𝐾 .

Let the price of an oven which here represents the price of Hence the value of output produced by the unit of
a capital good be 𝑝 𝐾 . capital good is 𝑃𝑡 × 𝑀𝑃𝐾 = 𝑃𝑡 𝑀𝑃𝐾 .

The baker can do two things:

Put the money into the bank for a year and then the return
is the interest earned on that sum of money, or, 𝑟𝑝 𝐾 .

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Arbitrage implies that the two alternative uses of the money

The capital good is subject to wear and tear or depreciation will be equal
at the rate 𝑑
𝐾
𝑟𝑝𝑡𝐾 = 𝑃𝑡 𝑀𝑃𝐾 + 1 − 𝑑 𝑝𝑡+1 − 𝑝𝑡𝐾
The price of the capital when it is being sold at the end of
the accounting period in the used-capital market is 𝐾 𝐾
𝐾
𝑝𝑡+1 . or, 𝑃𝑡 𝑀𝑃𝐾 = 𝑟𝑝𝑡𝐾 + 𝑝𝑡𝐾 − 𝑝𝑡+1 + 𝑑𝑝𝑡+1

𝐾
Hence the value of the unit of capital at 𝑡 + 1 is 1 − 𝑑 𝑝𝑡+1 . Rearranging the terms,
𝐾 𝐾
𝑃𝑡 𝑀𝑃𝐾 = 𝑟𝑝𝑡𝐾 + 𝑑𝑝𝑡+1 − 𝑝𝑡+1 − 𝑝𝑡𝐾
The capital gain, taking into account depreciation on the unit
of capital that is utilized for a period of time to produce
an output, then, is 1 − 𝑑 𝑝𝑡+1 𝐾
− 𝑝𝑡𝐾 . Let the percentage change in the price of a unit of capital in
the time period between 𝑡 and 𝑡 + 1 be
𝐾
The unit of capital that is acquired for production and then 𝑝𝑡+1 − 𝑝𝑡𝐾 Τ𝑝𝑡𝐾 = 𝛼
sold in the used-capital market then gives a return of
𝐾
𝐾
𝑃𝑡 𝑀𝑃𝐾 + 1 − 𝑑 𝑝𝑡+1 − 𝑝𝑡𝐾 This implies that 𝑝𝑡+1 = 1 + 𝛼 𝑝𝑡𝐾

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𝐾
𝑝𝑡+1 − 𝑝𝑡𝐾
𝑃𝑡 𝑀𝑃𝐾 = 𝑟𝑝𝑡𝐾 + 𝑑𝑝𝑡+1
𝐾 𝐾
− 𝑝𝑡+1 − 𝑝𝑡𝐾 𝐾
𝑝𝑡+1 = 1 + 𝛼 𝑝𝑡𝐾 𝑃𝑡 𝑀𝑃𝐾 ≈ 𝑝𝑡𝐾 𝑟 + 𝑑 −
𝑝𝑡𝐾

𝐾
Then, 𝑃𝑡 𝑀𝑃𝐾 = 𝑟𝑝𝑡𝐾 + 𝑑 1 + 𝛼 𝑝𝑡𝐾 − 𝑝𝑡+1 − 𝑝𝑡𝐾 Owner of a unit of capital should consider three costs of
using that capital:
When 𝑑 and 𝛼 are small,
• The opportunity cost of the money used to purchase
𝐾
𝑃𝑡 𝑀𝑃𝐾 ≈ 𝑟𝑝𝑡𝐾 + 𝑑𝑝𝑡𝐾 − 𝑝𝑡+1 − 𝑝𝑡𝐾 the unit of capital to pay for the unit of capital, 𝑟𝑝 𝐾 .
𝐾 • That the price of the unit of capital can change. This
𝑝𝑡+1 − 𝑝𝑡𝐾
or, 𝑃𝑡 𝑀𝑃𝐾 ≈ 𝑝𝑡𝐾 𝑟 + 𝑑 − 𝐾
part of the user cost is − 𝑝𝑡+1 − 𝑝𝑡𝐾 .
𝑝𝑡𝐾
• The unit of capital loses a fraction of its value because
Term on the right hand side is known as the user cost of
it is subject to wear and tear at a rate of depreciation
capital
of 𝑑 each period. The depreciation cost is 𝑑𝑝 𝐾 .

Firm should invest in capital until the value of the additional

output the capital produces, 𝑃𝑡 𝑀𝑃𝐾 , equals to the user cost

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3

K*
Figure 4.1: Optimal stock of capital
13
When we determine the profit maximizing level of capital we
∗
are asking what is the capital to be installed 𝐾 ∗ = 𝐾𝑡+1
so that in the next period 𝑡 + 1 when the capital prod-
uces an output that generates revenues we will be
maximizing profits.
The marginal product of capital curve then is that
associated with the output that is expected to be
sold the next period
It implies that a shift in the marginal product of capital curve
is associated with shifts in expected future income and
output.
A change in expected future income that is associated with
either an increase in productivity that is expected, or
the expectation of a booming economy, will shift the
𝑀𝑃𝐾 curve to the right and result in an increase in the
∗
capital up to the level 𝐾 ∗ = 𝐾𝑡+1
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The amount of capital 𝐾 ∗ is the level of capital the firm would
∗
desire to obtain by the next period, or, 𝐾 ∗ = 𝐾𝑡+1 .
If the capital stock currently 𝐾𝑡 is less than 𝐾 ∗ the firm needs
to invest the difference in capital stock,
∗
𝐾 ∗ − 𝐾𝑡 = 𝐾𝑡+1 − 𝐾𝑡
∗
Net Investment = 𝐾 ∗ − 𝐾𝑡 = 𝐾𝑡+1 − 𝐾𝑡
It is net investment because it does not take account of the
capital goods that need to be replaced due to dep-
reciation
K
Gross investment = Net investment + depreciation
Capital
Depreciation = 𝑑𝐾𝑡
∗
Gross Investment = 𝐼𝑡 = 𝐾𝑡+1 − 𝐾𝑡 + 𝑑𝐾𝑡
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Financing constraints and financial frictions ─
Asymmetric information can cause the cost of internal finance
to differ substantially from external finance, and makes
the availability of finance a constraint on investment.
Managers of a firm have full information about the value of
the firms’ existing assets and the returns from new
investment projects.
A potential lender may not have this information.
This leads to two types of asymmetric information problems ─
• Adverse selection and
• Moral hazard.
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Financial intermediaries seek to overcome the adverse select-

ion and moral hazard problems they face by collecting
information. Monitoring is undertaken to prevent those hidden actions or
moral hazard that can occur once the loan is taken out
Banks for instance routinely screen and monitor borrowers which can compromise the repayments of the loan.

The loan officer will routinely check on the borrower to

Screening involves collecting information about potential
see if they are using the funds appropriately and
borrowers before the loan transaction
check for signs of risky behaviour.
Banks use information systems to identify clients with
The bank has an advantage in monitoring as it can
poor credit records and stockbrokers employ com-
observe the borrowers bank account and detect
pany analysts to tell them about the financial
unusual account activity and keep track of the
health of companies.
borrower’s financial condition.
Banks screen by asking those who want a loan to provide
details about their income, their employment
record, the value of assets such as shares and
house if owned, and details of bank accounts from
which they can ascertain details of financial
behaviour and the ability to meet due payments

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Collateral requirements are another mechanism used by
banks to reduce adverse selection and moral hazard
problems.
Collateral is the asset that is promised by the borrower
to the lender in case the borrower defaults on the debt
Financial frictions arise because it is unknown as to how
productive a capital investment project will be and no
matter how carefully estimated in advance the outcome
of the project always contains a surprise element.
That is to say there are idiosyncratic productivity shocks.

Borrowers supply collateral & pledge assets as it red- Asymmetry ─

uces the risk to the lender of giving the loan and inc- Realized value of the productivity is observed by the
reases the likelihood of obtaining the loan entrepreneur
Creditor can only observe it by incurring a monitoring
If the asset can easily be liquidated then the loan may cost
also be given at a lower interest rate.
Lender knows that a fraction of entrepreneurs will experience
a low productivity shock and will be unable to fully
Collateral – reduces incentive of borrower to engage in
repay the interest and principal on the loan. In such
excessive risk. If they engage in risky behaviour and
cases the lender will get the pledged collateral and the
cannot pay back the loan they lose the asset. – The
value of assets declared via bankruptcy.
borrower then has “skin in the game”.

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5

Higher is estimate of entrepreneurs subject to negative
shocks to productivity ─ higher the interest rate
charged on loans due to concern that larger number
of projects are expected to fail
Credit spread ─ higher interest rate charged due to concern
of larger no. of projects expected to fail as a premium
over interest rate on safe assets that are guaranteed
to pay back such as government bonds ─ is a prem-
ium as a cover for risk associated with project having
negative productivity shock.
Such higher credit spreads cause entrepreneurs to
borrow less.
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Higher hidden information or asymmetric information results
in financial frictions that impair the functioning of the credit
market due to
Adverse selection ─ borrower desirous to obtain a
loan is one who is engaged in projects that
have a higher chance of being unable to pay
back which is an undesirable or adverse out-
come for the lender.
Lenders then charge higher credit spreads and ration
credit.
Interest rate that is applicable when considering investment
decisions = the real interest rate on safe or default free
debt instruments such as government bonds + the
credit spread associated with the probability that the
borrower will default on repayments from financial
frictions arising from productivity shocks.
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Increase in credit spread ─ invites those entrepreneurs to
take a loan who have riskier projects that have a
likelihood of earning returns over and above the
credit spread.
Lender realizes that riskier borrowers will apply for loans
when credit spreads are raised and will prefer to limit
the borrowing and will ration credit
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Increase in risk associated with project outcomes and the
associated financial friction
─ increase in chance of default on credit repayment
resulting in credit spread being increased.
𝑓: the credit spread arising from financial frict-
ion.
𝑟: real interest rate on risk free debt
𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝑟 + 𝑓
An increase in borrowing cost, or an increase in 𝑟 + 𝑓 is
an increase in the user cost of capital.
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Errol D’Souza

𝐾
The firm should invest in capital till the additional output the 𝑝𝑡𝐾 𝑝𝑡+1 − 𝑝𝑡𝐾
𝑀𝑃𝐾 ≈ 𝑟+𝑓+𝑑−
capital produces, 𝑀𝑃𝐾 , equals to the user cost 𝑃𝑡 𝑝𝑡𝐾

𝑝𝑡𝐾 𝐾 −𝑝𝐾
𝑝𝑡+1 𝑡 Since the economy is being depicted in terms of a single agg-
𝑀𝑃𝐾 ≈ 𝑟+𝑓+𝑑−
𝑃𝑡 𝑝𝑡𝐾 regate good, we can write 𝑝𝑡𝐾 = 𝑃𝑡 , or, 𝑝𝑡𝐾 Τ𝑃𝑡 = 1.
Investment decisions are influenced then by the following factors ─
We can then write the above as investment is undertaken
• the productivity of the capital, 𝑀𝑃𝐾 , where a rise in product- till the point where,
ivity such as occurs in an upswing of the business
𝐾
cycle leads to more investment. 𝑝𝑡+1 − 𝑝𝑡𝐾
𝑀𝑃𝐾 − 𝑓 − 𝑑 + ≥𝑟
• the real price of capital, 𝑝𝑡𝐾 Τ𝑃𝑡 , an increase in which reduces 𝑝𝑡𝐾
investment.
• the real interest rate, 𝑟. An increase in 𝑟 reduces investment
• the expected rate of change of the price of capital,
𝐾
𝑝𝑡+1 − 𝑝𝑡𝐾 Τ𝑝𝑡𝐾 .
• the depreciation rate, 𝑑.
• financing constraints that are due to financial frictions, 𝑓.

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Errol D’Souza Errol D’Souza

𝐾 𝐾
𝑝𝑡+1 − 𝑝𝑡𝐾 𝑝𝑡+1 − 𝑝𝑡𝐾
𝑀𝑃𝐾 − 𝑓 − 𝑑 + ≥𝑟 𝑀𝑃𝐾 − 𝑓 − 𝑑 + ≥𝑟
𝑝𝑡𝐾 𝑝𝑡𝐾

Unit of capital that is employed produces an additional output
given by its marginal product, 𝑀𝑃𝐾 , and
the capital loses a fraction of its value given by the rate
of depreciation, 𝑑,
but gains value in terms of a capital gain, 𝐾 − 𝑝 𝐾 ൗ𝑝 𝐾
𝑝𝑡+1 𝑡
If there are financial frictions, 𝑓, then this is an element
of the cost to be paid to acquire the unit of cap-
ital and this cost is to be incurred out of the add-
itional output that it produces
Write the left-hand side of the above inequality as 𝑀𝑃𝐾𝑛𝑒𝑡
Then, investment should be undertaken depending on the gap
between 𝑀𝑃𝐾𝑛𝑒𝑡 and the real interest rate, 𝑟.
If the net addition to output from the investment in capital,
𝑡
𝑀𝑃𝐾𝑛𝑒𝑡 , is low relative to the real interest rate, firms
would benefit from saving their retained earnings in
the financial market by buying government bonds.
Alternatively, if the net additional output from the investment
in capital is high relative to the real interest rate, then
the firms find it profitable to borrow at the real interest
rate and invest it in increasing the stock of physical
capital which leads to a rise in investment

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Errol D’Souza
𝐾
𝑝𝑡+1 − 𝑝𝑡𝐾
𝑀𝑃𝐾 − 𝑓 − 𝑑 + ≥ 𝑟 ⇒ 𝑀𝑃𝐾𝑛𝑒𝑡 ≥ 𝑟 Residential or Housing Investment ─
𝑝𝑡𝐾

We can then write, Investment in housing and residential structures refers to

𝐼 = 𝑏 𝑀𝑃𝐾𝑛𝑒𝑡 − 𝑟 expenditure on new housing units and on the maint-
enance and improvement of existing units

Define the parameter 𝑎 = 𝑏𝑀𝑃𝐾𝑛𝑒𝑡 = 𝑏 𝑀𝑃𝐾 − 𝑓 − 𝑑 +

𝐾 −𝑝𝐾
𝑝𝑡+1 𝑡 𝑝𝑡𝐻 ∶ current price of a unit of housing
𝑝𝑡𝐾 𝑥∶ Funds available in rupee terms with the investor
that can be used as a down payment for the
Then, investment is given by, purchase of an apartment
𝐼 = 𝑎 − 𝑏𝑟
𝑝𝑡𝐻 − 𝑥 : amount the investor needs to borrow

or, 𝐼 = 𝑎 − 𝑏 𝑖 − 𝜋𝑒 𝑟: the interest rate

Mortgages are usually tax deductible. If the tax rate is 𝜏,

𝑟 1 − 𝜏 : cost of borrowing

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Return on investment in housing –

𝐻
𝑅: Rent earned by investor on renting out the apart- 𝑅 + 𝑝𝑡+1 1 − 𝑑 − 𝑝𝑡𝐻 − 𝑟 1 − 𝜏 𝑝𝑡𝐻 − 𝑥
ment

𝑑: rate at which house depreciates. Alternative option is to put the sum of 𝑥 in the bank and
earn a return of 𝑟𝑥.
𝐻
𝑝𝑡+1 1 − 𝑑 : Sale value of unit of housing after a year.
Arbitrage requires that the two options provide the same
return
Return from investing in the apartment then is ─ 𝐻
𝑟𝑥 = 𝑅 + 𝑝𝑡+1 1 − 𝑑 − 𝑝𝑡𝐻 − 𝑟 1 − 𝜏 𝑝𝑡𝐻 − 𝑥
𝑅 , rent earned, plus
𝐻
𝑝𝑡+1 1 − 𝑑 , or sale value after a year,
Dividing throughout by 𝑝𝑡𝐻 ,
less
𝑝𝑡𝐻 , the price paid to purchase the house, 𝑟𝑥 𝑅
= 𝑝𝐻 +
𝐻 −𝑝 𝐻
𝑝𝑡+1 𝑡
−𝑑
𝐻
𝑝𝑡+1
−𝑟 1−𝜏
𝑥
1 − 𝑝𝐻
𝑟 1 − 𝜏 𝑝𝑡𝐻 − 𝑥 , or, cost of the mortgage on the am- 𝑝𝑡𝐻 𝑡 𝑝𝑡𝐻 𝑝𝑡𝐻 𝑡

ount borrowed above the down payment made

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𝑟𝑥 𝑅 𝐻 −𝑝 𝐻
𝑝𝑡+1 𝐻
𝑝𝑡+1 𝑥 𝑟𝑥 𝑅 𝐻 −𝑝 𝐻
𝑝𝑡+1 𝐻
𝑝𝑡+1 𝑥
𝑡 𝑡
𝑝𝑡𝐻
= 𝑝𝐻 + 𝑝𝑡𝐻
−𝑑 𝑝𝑡𝐻
−𝑟 1−𝜏 1 − 𝑝𝐻 𝑝𝑡𝐻
= 𝑝𝐻 + 𝑝𝑡𝐻
−𝑑 𝑝𝑡𝐻
−𝑟 1−𝜏 1 − 𝑝𝐻
𝑡 𝑡 𝑡 𝑡

𝐻
𝑥෤ = 𝑥 Τ𝑝𝑡𝐻 : 𝑝𝑡+1
Let the rate of increase in house prices be given by 𝛼 where 𝑑 𝐻 =𝑑 1+𝛼 ≈𝑑
𝑝𝑡
𝐻
𝑝𝑡+1 = 1 + 𝛼 𝑝𝑡𝐻 .
𝐻
𝑝𝑡+1 − 𝑝𝑡𝐻 𝑅
𝑝𝐻
Then, 𝑟 𝑥෤ − + 𝑑 + 𝑟 1 − 𝜏 1 − 𝑥෤ = 𝐻
Then, 𝑑 𝑡+1 = 𝑑 1+𝛼 𝑝𝑡𝐻 𝑝𝑡
𝑝𝑡𝐻
Using the approximation that when 𝑑 and 𝛼 are small, This simplifies to
𝑑 1 + 𝛼 ≈ 𝑑.
𝐻
𝑝𝑡+1 −𝑝𝑡𝐻 𝑅
Define, 𝑟𝜏𝑥෤ + 1 − 𝜏 𝑟 + 𝑑 − = 𝑝𝐻
𝑝𝑡𝐻 𝑡

𝑥෤ = 𝑥 Τ𝑝𝑡𝐻 : the fraction of the house price that is to be given 𝐻

𝑅 + 𝑝𝑡+1 − 𝑝𝑡𝐻
as a down payment or, 𝑟𝜏𝑥෤ + 1 − 𝜏 𝑟 + 𝑑 =
𝑝𝑡𝐻
𝑥෤ is the inverse of leverage, 𝑝𝑡𝐻 Τ𝑥
Benefit from purchase
of apartment

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𝐻
𝑅 + 𝑝𝑡+1 − 𝑝𝑡𝐻 𝐻
𝑅 + 𝑝𝑡+1 − 𝑝𝑡𝐻
𝑟𝜏𝑥෤ + 1 − 𝜏 𝑟 + 𝑑 = 𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑 =
𝑝𝑡𝐻 𝑝𝑡𝐻

The terms 𝑟𝜏𝑥෤ + 1 − 𝜏 𝑟 may be written as 𝑟 1 − 𝜏 1 − 𝑥෤ Benefit from purchase

of apartment

𝑝𝑡𝐻 Left-hand side then is the sum of

If 𝑥෤ = = 1, then 𝑝𝑡𝐻 = 𝑥, or, there is no borrowing to • the opportunity cost of borrowing which is the interest
𝑥
fund the purchase of the apartment. on the loan net of the tax deductible on it,
𝑟 1 − 𝜏 1 − 𝑥෤ , and
Then, 𝑟 1 − 𝜏 1 − 𝑥෤ = 𝑟, which is the opportunity cost • the rate of depreciation of the apartment, 𝑑
of own funds that have been provided for as a down We can rewrite the arbitrage equation as
payment to fund the entire purchase of the apart-
ment. 𝐻 −𝑝 𝐻
𝑝𝑡+1 𝑡 𝑅
𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑− = 𝑝𝐻
𝑝𝑡𝐻 𝑡
Thus, 𝑟 1 − 𝜏 1 − 𝑥෤ is the reduction in the opportunity
cost due to tax deductibility provided for on the Or, cross multiplying,
loan taken so as to purchase the apartment.
𝐻 −𝑝 𝐻
𝑝𝑡+1
𝑝𝑡𝐻 𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑− 𝑡
=𝑅
𝑝𝑡𝐻

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𝐻
𝑝𝑡+1 − 𝑝𝑡𝐻
𝑝𝑡𝐻 𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑− =𝑅
𝑝𝑡𝐻 The demand for housing services will then be inversely
related to the price of the services provided by the
𝑅 is the benefit or the value of services that are house which is the rent paid
provided by the apartment per time period as
given by the rent, and At the point where the downward sloping demand curve
for housing intersects the user cost the equilibrium
𝑝𝑡𝐻 𝑟 1 − 𝜏 1 − 𝑥෤ 𝐻
+ 𝑑 − 𝑝𝑡+1 − 𝑝𝑡𝐻 Τ𝑝𝑡𝐻 is the user cost. quantity of demand for investment in housing is
determined.

The quantity of housing (say the square feet of housing) is a

stock measured in terms of the value of the house
(price per square foot × square feet of housing) and
this stock of housing generates a flow of income per
year that is known as the rent which is paid for the
flow of services that the house provides such as
security, privacy, etc.

37 38

Rental price of housing

𝐻
𝑝𝑡+1 − 𝑝𝑡𝐻 Residential housing takes time to build and additionally
𝑅 = 𝑝𝑡𝐻 𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑− the depreciation rate is low.
𝑝𝑡𝐻
Rent Hence, in the short run the stock of residential hous-
ing is a given and that is represented by
the vertical line.
Rental on Housing
The demand for housing stock equals
the supply of housing stock and the
𝑅 User cost housing market is in short-run equil-
ibrium. .

Demand for housing A disturbance to this equilibrium pos-

𝑅 ition can arise due to say a shift in the
demand for housing. An increase in
Housing D incomes or population will increase
Kh *
Stock the demand for housing.

K h ,t = K h * Housing
Stock

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𝐻
Demand for housing shifts to 𝐷 / as incomes or population increase 𝑝𝑡+1 − 𝑝𝑡𝐻
𝑝𝑡𝐻 𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑− =𝑅
𝑝𝑡𝐻
Rental on Housing Rental on Housing
𝑅
Panel (a) Panel (b) or, 𝑝𝑡𝐻 = 𝐻
𝑝𝑡+1 − 𝑝𝑡𝐻
𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑−
𝑝𝑡𝐻

𝑅/ With an increase in 𝑅 and no change in any of the other

parameters that are part of user cost, 𝑟, 𝜏, 𝑥,
෤ 𝑑,
𝐻
𝑅 𝑝𝑡+1 − 𝑝𝑡𝐻 Τ𝑝𝑡𝐻 , clearly the variable that must rise for
D/ the above equation to hold is the price that is
D Investment D directly proportional to the rental 𝑅.
in new
housing
The term in the denominator is called the capital-
K h ,t = K h * Housing K h ,t K h**,t +1 Housing ization rate – the rate that converts the rent
Stock Stock into the market price.
With excess demand the rental rate in the housing market will rise
to 𝑅/ .

41 42

As the price of existing homes has been driven up, the market
valuation of the existing housing stock has increased.
Rental on Housing Rental on Housing
As the price of housing rises builders profit by building Panel (a) Panel (b)

more housing and their supply of housing like

any supply in a market rises with the price of
housing 𝑅/

Builders and developers respond to this demand for housing

by consumers by building new homes when the existing 𝑅
D/
home prices rise relative to the price at which existing D D
Investment
homes were sold. The amount of investment in building in new
housing
new homes is given by
K h ,t = K h * Housing K h**,t +1 Housing
∗∗
𝐼ℎ = 𝐾ℎ,𝑡+1 − 𝐾ℎ,𝑡 K h ,t
Stock Stock

With an increase in rentals the price of housing increases

∗∗
and builders invest more, where, 𝐼ℎ = 𝐾ℎ,𝑡+1 − 𝐾ℎ,𝑡 .

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11

𝑅 𝑅
𝑝𝑡𝐻 = 𝐻 𝑝𝑡𝐻 =
𝑝𝑡+1 − 𝑝𝑡𝐻
𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑−
𝑝𝑡𝐻
The price of an apartment is the present discounted value of
the amount you can earn by renting it out.
𝐻
There is a capital appreciation term, 𝑝𝑡+1 − 𝑝𝑡𝐻 Τ𝑝𝑡𝐻 , in the
discount term and it indicates that the more there is
going to be capital appreciation the higher is the price
of housing today.
This is how house price bubbles begin and are rein-
forced.
45
Inventory Investment
Inventories are goods that have been produced but have not
yet been sold.
• Production smoothing involves firms continuing to produce
when sales are temporarily low and putting the
unsold produce into inventory.
When sales are temporarily high they do not raise
production and instead draw down inventories
to cater to the higher demand.
Implies that inventory investment is countercyclical
where firms accumulate inventories during
recessions and draw down inventories during
cyclical upswings.
47
17-10-2023
𝐻
𝑝𝑡+1 − 𝑝𝑡𝐻
𝑟 1 − 𝜏 1 − 𝑥෤ +𝑑−
𝑝𝑡𝐻
Consider too the term 𝑥෤ in the denominator.
𝑥෤ declines ─ increase in leverage ─ financial markets
bear larger cost of apartment ─ price of apart-
ments rise.
Sub-prime mortgage crisis that began in 2007 was in part
because of the lowering of credit standards where the
down payments required for a loan were reduced
significantly.
Many subprime mortgages required no downpayment
or documentation of borrower financial cond-
itions.
46
• If we observe that inventory investment is not counter-
cyclical but instead is high when the economy is
booming and low during recessions then it could
be due to stock-out avoidance.
Stock-out avoidance is driven by the motivation to hold
inventories so as to avoid running out of goods and
thereby losing sales.
When sales are surprisingly high a firm can run out
of goods to sell and thereby lose a customer.
To avoid losing such sales firms will hold
inventories in order to not stock out of goods.
48
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• Another reason for procyclicality of inventories ─

pipeline proposition

This proposition applies to input inventories such as

raw materials and work in progress as opposed
to output inventories such as finished goods

Firms hold inventories of work in process which is the

holding of partially finished components that
go into the final product.

When demand increases and the firm needs to ramp

up production its collection of components
will rise as part of the production process

49

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