ECON 6305: Notes on Investment in RBC

Models
Aaron Betz
George Washington University

1 A Simple Model
Tobin’s Q is a measure of the market value of capital assets relative to their
replacement value.
 
>1 Invest
M arketV alue  
q= =1 Indif f erent
ReplacementV alue 
<1 Divest


(1)

This is the ratio of the market value of the installed capital in a firm over
the cost of new replacement capital. If the market value of the installed capital
is greater than the cost of buying new capital to replace it, then Tobin’s q is
greater than one. This also means that a new unit of capital can be installed in
the firm and it will increase in value. Similarly, if the value of installed capital
within a firm is less than its replacement cost (q < 1), then the capital is more
valuable outside the firm and the firm would be better off selling capital or
divesting.

2 Tobin’s Q in RBC Models

Real business cycle (RBC) models contain forward looking agents that choose
to invest in capital or consume their income. RBC agents see this tradeoff as
utility from consumption today versus future utility from consumption derived
from returns on investment made today. In the RBC model agents calculate
dsicounted future utility derived from an additional unit of capital and the
marginal amount of utility lost from a unit of investment. The ratio of these
two calculation is simply Tobin’s Q (valued in utils). When a unit of investment
transforms directly into a unit of capital and the price of investment is the same
as that of consumption, we will show that the RBC agent invests up until the

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point that Tobin’s Q is exactly equal to one. Consider the simple RBC model
below.

The RBC household or agent solves the following maximization problem.

∞
X
max β t u(ct )
ct ,xt ,kt
t=0

such that:
ct + xt = wt lt + rt kt−1
and
kt = (1 − δ)kt−1 + xt .
We can transform this into a Lagrangian with two multipliers.
∞
X
max Lt = β t [u(ct )
ct ,xt ,kt
t=0
(2)
+ λt (−ct − xt + wt lt + rt kt−1 )
+ Qt (−kt + (1 − δ)kt−1 + xt )
The first order condition with respect to capital, kt , simplifies to
Qt = β [(1 − δ)Qt+1 + λt+1 rt+1 ] . (3)
Recall that the Langrange multipliers, Qt andλt , represent the marginal increase
in the objective function if the given constraint is expanded (assuming an inte-
rior solution). The value of λt is then the amount of utility, at the margin, that
would be gained from expanding the budget constraint by one. The value of Qt
is the amount of utility, at the margin, that would be gained from expanding
the capital constraint by one. Qt is then the value (in utils) that the RBC agent
places on an additional unit of capital at time t. The first order condition on
capital then tells us that the value of an additional unit of capital today should
be equal to the value of an extra unit of depreciated capital tomorrow plus the
value of an additional rt of either consumption or investment. Additionally, ob-
serve that at the margin, the ratio of Qt /λt represents the value to the agent (in
utils) of a unit of installed capital relative to a unit of investment (i.e., Tobin’s
Q).

The first order condition on investment, xt , simplifies to

Qt = λt . (4)
This tells us that the RBC agent maximizes utility by setting Tobin’s Q, Qt /λt ,
equal to one. Furthermore, we can derive an expression for Tobin’s Q by dividing
both sides of equation 3 by λt .
Qt λt+1
qt = =β [(1 − δ)qt+1 + rt+1 ] (5)
λt λt

2
This equation gives some intuiton if we look at it in steady state. This reduces
to
q̄ = β [(1 − δ)q̄ + r̄] . (6)
Since we know qt is equal to one then this reduces to our standard arbitrage
condition on interest or net returns.
1
= 1 + r̄ − δ (7)
β
This states that the net return in steady state (r̄ − δ) must equal the internal
discount rate, 1−β
β in the RBC agent’s utility function.

3 Distortions with Tobin’s Q in RBC

There are three ways Tobin’s Q can be not equal to one in equilibrium.

3.1 Investment Adjustment Costs

If introduce an adjustment cost on investment, as seen below in the function S,
then it may be the case that the maximizing RBC agent chooses an outcome
in which Tobin’s Q is not equal to one. Why? Because the cost of adjusting
investment changes the relative price of investment to consumption. In other
words if the first unit of investment incurs no adjustment cost but the second
unit incurs an adjustment cost, then the price (or cost) of a new unit of capital
relative to consumption in changes between the first and second unit.
 2
xt
kt = (1 − δ)kt−1 + 1 − xt .
xt−1

3.2 Taxes and Relative Price Changes

Consider a tax, τ , on investment in the budget constraint below.
ct + (1 + τ )xt = wt lt + rt kt−1
Taking the first order condition on investment in this model yields
(1 + τ )λt = Qt (8)
This means in equilibrium Tobin’s Q equals (1 + τ ), the relative after-tax rice
of investment to consumption. Similarly, consider what happens when we in-
troduce an investment productivity shock, µt , as seen below.
kt = (1 − δ)kt−1 + µt xt .
The shock does not change the relative price of consumption to investment but
it does change the relative price of capital to consumption. The first order
condition on investment appears below.
λt = Qt µt (9)
1
Tobin’s Q is now equal to µt in equilibrium.

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3.3 Practice Problem 1
1. Consider what happens when a consumption tax is introduced in the fol-
lowing budget constraint. What is Tobin’s Q? Is it greater than one or
less than one with τ > 0.

(1 + τ )ct + xt = wt lt + rt kt−1

2. Derive equation 5 in a model with an investment productivity shock µt .

kt = (1 − δ)kt−1 + µt xt .