University of Illinois at Urbana Champaign Department of Economics Econ 303 Intermediate Macroeconomics Lecture Note 3 Prof Ricardo Bebczuk Spring 2024 Investment Short Run Macroeconomics Who Spends s r o t c e S l a n o i t u t i t s n I Households Businesses Government Rest of the World Private Consumption Corporate Investment Fiscal spending and revenues Trade and Current Account Balance National Gross Investment to GDP by Country Groups 1980 2023 World Major advanced countries G7 Emerging and Developing Countries 33 5 27 2 22 6 US 2023 20 9 35 33 31 29 27 25 23 21 19 17 15 0 8 9 1 2 8 9 1 4 8 9 1 6 8 9 1 8 8 9 1 0 9 9 1 2 9 9 1 4 9 9 1 6 9 9 1 8 9 9 1 0 0 0 2 2 0 0 2 4 0 0 2 6 0 0 2 8 0 0 2 0 1 0 2 2 1 0 2 4 1 0 2 6 1 0 2 8 1 0 2 0 2 0 2 2 2 0 2 Source IMF 2023 World Economic Outlook April https www imf org en Publications WEO weo database 2023 April What We Talk about when We Talk about Investment World Composition of Gross Investment by Institutional Sector 14 25 61 Households Businesses Government Source Bebczuk and Cavallo 2016 https www tandfonline com doi abs 10 1080 00036846 2015 1117050 From Gross National Investment to Net Corporate Investment Gross investment Net investment Depreciation Capital stock t Capital stock t 1 Net investment t Variable world averages of GDP Gross National Investment Y C I G NX Gross Corporate Investment Depreciation 24 15 9 Net Corporate Investment 6 Source Data from Bebczuk and Cavallo 2016 https www tandfonline com doi abs 10 1080 00036846 2015 1117050 Business Investment Theories Keynesian Investment Function I i0 i1 Y I Investment Y GDP i0 Autonomous investment independent of GDP in particular depreciation i1 Marginal propensity to invest MPI I Y This is sometimes called the accelerator effect as investment accelerates or slows down depending on the level of GDP When the economy is up it means that firms face a larger demand for their products and so will expand their productive capacity The argument also operates in reverse Towards a better investment model The Keynesian model suffers from some serious limitations 1 It does not follow from a more complete model where firms maximize profits This is usually referred to as an ad hoc just for this in Latin model in the sense that the formulation lacks a model based justification 2 It makes investment depend on the current level of GDP not the expected level which in theory is more relevant 3 It has no role for the interest rate or other investment drivers As a result we need a better model pivoting around the supply and demand for funds as shown next Drivers of business investment Expected profitability Supply of funds and cost of capital Uncertainty by irreversibility Supply of funds and cost of capital under imperfect financial markets Sources and Cost of Capital A company can cover its investment expenditures with Internal Funds also called reinvested earnings or business saving Debt bank loans or bonds both with predetermined interest rate and maturity and a clause enabling creditors to seize assets in the event of default Stock profit and loss sharing with no return nor duration contractually established and thus default and so foreclosure free Unlike internal funds debt and stock are external funds supplied by outsiders Cumulative annual return of different asset classes 1928 2022 The Equity Premium 10 9 6 If you had invested 100 in stocks in 1928 how much money would you have in 2022 The answer is 624 534 55 6 7 4 6 3 3 9 8 7 6 5 4 3 2 1 0 S P 500 US Treasury Bill US Treasury Bond Baa Corporate Bond Source Data from https www stern nyu edu adamodar pc datasets histretSP xls Annual standard deviation of different asset classes 1928 2022 The Equity Premium 19 6 20 18 16 14 12 10 8 6 4 2 0 8 0 7 8 3 0 S P 500 US Treasury Bill US Treasury Bond Baa Corporate Bond Source Data from https www stern nyu edu adamodar pc datasets histretSP xls Definition and types of asymmetric information Asymmetric Information AI The borrower has more information than the lender and is willing to use it to obtain a rent at the expense of the latter What can he she lie about The expected cash flows from the project and or the probability of success Pioneers Akerloff 1970 Spence 1976 and Stiglitz 1981 Economics Nobel Prize Laureates in 2001 Source Bebczuk chapter1 book edition https assets cambridge org 97805217 93421 sample 9780521793421ws pdf Key novel lessons of the AI school There is a conflict of interest between dishonest insiders and poorly informed but smart outsiders This would lead to an advantage of the former over the latter if you re not at the table you re on the menu Plot twist 1 the misinformed party insulates itself by tightening credit standards less credit higher rate shorter maturity collateral This is sand on the financial system wheels Main victim Good projects in need of external funding Plot twist 2 Some government interventions might help to alleviate this market failure public banks state loan guarantees strict licensing requirements and regulations on financial intermediaries and many others Limited Liability AI is a problem only if there exists limited liability Limited liability In case of failure the entrepreneur cannot lose more than his her initial investment in the firm regardless of his personal wealth Rephrasing the entrepreneur s liability is limited to the personal resources sunk into the firm A highly or fully leveraged entrepreneur 100 debt and no own funds is prone to hide information from the lender and take excessive risk because If successful he ll have big profits and will repay the debt If not he loses nothing it was other people s money Question Why is there limited liability after all Donald Trump has filed for corporate bankruptcy four times 1991 1992 2004 and 2009 He has never filed for personal bankruptcy Definition and forms of asymmetric information Forms in chronological order 1 Adverse Selection High risk applicants try to disguise themselves as low risk 2 Moral Hazard Once the loan is disbursed the borrower takes a riskier project than promised 3 Monitoring Costs Once the project is finalized the successful entrepreneur falsely declares default AS MH MC Moral Hazard The Madoff saga Ran Ponzi scheme until 2008 defrauding investors for an estimated 65 billion Promised returns of up to 46 Clients included big banks charities and celebrities like Steven Spielberg and Kevin Bacon Bacon number 1 How much was recovered 3 6 billion Moral Hazard The Madoff saga