Chapter 17

CAPITAL MARKETS

Copyright ©2005 by South-Western, a division of Thomson Learning. All rights reserved. c

 Capital
Ô The capital stock of an economy is the
sum total of machines, buildings, and
other reproducible resources in existence
at a point in time
± these assets represent some part of the
economy¶s past output that was not
consumed, but was instead set aside for
future production

d
 •ate of •eturn
At period Y1, a decision is made to hold from
Consumption current consumption for one period
is used to produce additional
output only in period Y2


-utput in period Y2 rises by

0

Consumption returns to
its long-run level (0) in
period Y3

Time
Y1 Y2 Y3
u
 •ate of •eturn
Ô The single period rate of return (?1) on
an investment is the extra consumption
provided in period 2 as a fraction of the
consumption forgone in period 1
M
1 M1
 

]
 •ate of •eturn
At period Y1, a decision is made to hold from
Consumption current consumption for one period
is used to produce additional
output in all future periods


Consumption rises to
0 0 +  in all future

periods

Time
Y1 Y2 Y3
’
 •ate of •eturn
Ô The perpetual rate of return (?6) is the
permanent increment to future
consumption expressed as a fraction of
the initial consumption foregone
y
r ë
s

Ú
 •ate of •eturn
Ô When economists speak of the rate of
return to capital accumulation, they have
in mind something between these two
extremes
± a measure of the terms at which
consumption today may be turned into
consumption tomorrow

m
 •ate of •eturn and
Price of Future Goods
Ô Assume that there are only two periods
Ô The rate of return between these two
periods (?) is defined to be
ë
M
ë
Ô Rewriting, we get
ë c
ëc cô 
 •ate of •eturn and
Price of Future Goods
Ô The relative price of future goods (|1) is
the quantity of present goods that must
be foregone to increase future
consumption by one unit

c
|c

c cô

ÿ
 remand for Future Goods
Ô An individual¶s utility depends on
present and future consumption
‰
‰(0,1)
and the individual must decide how
much current wealth () to devote to
these two goods
Ô The budget constraint is

0 + |11
c
 ‰tility Maximization

 0 + |1  1
0

^Î 1
The individual will maximize utility by
choosing to consume 0* currently and
1* in the next period
1* 

‰1

‰0

1
0* ^

cc
 ‰tility Maximization
Ô The individual consumes 0* in the
present period and chooses to save
  0* to consume next period
Ô This future consumption can be found
from the budget constraint
|11* =   0*
1* = ( - 0*)/|1
1* = (  0*)(1 + ?)
cd
 9ntertemporal 9mpatience
Ô Individuals¶ utility-maximizing choices
over time will depend on how they feel
about waiting for future consumption
Ô Assume that an individual¶s utility
function for consumption [‰()] is the
same for both periods but period 1¶s
utility is discounted by a ³rate of time
preference´ of 1/(1+X) (where X>0)
cu
 9ntertemporal 9mpatience
Ô This means that
ë ë
ë ë
X
Ô Maximization of this function subject to
the intertemporal budget constraint
yields the Lagrangian expression
 
g
 

  
c
c ? 
c

c]
 9ntertemporal 9mpatience
Ô The first-order conditions for a maximum
are
g
ë ' ë
ë
ë

g c
ë  c  ë

c c c ?

g
ë

{
ë{
 ? c’
 9ntertemporal 9mpatience
Ô
ividing the first and second conditions
and rearranging, we find
?
 {


X
Ô Therefore,
± if ? = X, 0 = 1
± if ? < X, 0 > 1
± if ? > X, 0 < 1
cÚ
 Ãffects of Changes in ?
Ô If ? rises (and |1 falls), both income and
substitution effects will cause more 1 to
be demanded
± unless 1 is inferior (unlikely)
Ô This implies that the demand curve for
1 will be downward sloping

cm
 Ãffects of Changes in ?
Ô The sign of 0/|1 is ambiguous
± the substitution and income effects work in
opposite directions
Ô Thus, we cannot make an accurate
prediction about how a change in the
rate of return affects current
consumption

c
 Úupply of Future Goods
Ô An increase in the relative price of
future goods (|1) will likely induce firms
to produce more of them because the
yield from doing so is now greater
± this means that the supply curve will be
upward sloping

cÿ
 Ã uilibrium Price of
Future Goods
|1 Equilibrium occurs at |1*
 and 1*

The required amount of

current goods will be put
into capital accumulation
1*
to produce 1* in the
future


1
1*

d
 Ã uilibrium Price of
Future Goods
Ô We expect that |1 < 1
± individuals require some reward for waiting
± capital accumulation is ³productive´
Ô sacrificing one good today will yield more than
one good in the future

dc
Phe à uilibrium •ate of •eturn
Ô The price of future goods is
|1* = 1/(1+?)
Ô ecause |1* is assumed to be < 1, the
rate of return (?) will be positive
Ô |1* and ? are equivalent ways of
measuring the terms on which present
goods can be turned into future goods
dd
 •ate of •eturn & •eal and
Nominal 9nterest •ates
Ô oth the rate of return and the real
interest rate refer to the real return that
is available from capital accumulation
Ô The nominal interest rate (•) is given by

ô ( ô ? )( ô e pected inflation rate)


  ?  p
du
 •ate of •eturn & •eal and
Nominal 9nterest •ates
Ô Expansion of this equation yields
 
c 
c
p
p

Ô

  ? p  




p

d]
Phe Firm¶s remand for Capital
Ô In a perfectly competitive market, a firm
will choose to hire that number of
machines for which the ~•
is equal to
the market rental rate

d’
 reterminants of Market
•ental •ates
Ô Consider a firm that rents machines to
other firms
Ô The owner faces two types of costs:
± depreciation on the machine
Ô assumed to be a constant % (J) of the machine¶s
market price (|)
± the opportunity cost of the funds tied up in
the machine rather than another investment
Ô assumed to be the real interest rate (?) dÚ
 reterminants of Market
•ental •ates
Ô The total costs to the machine owner for
one period are given by
|J  |?
|(?  J)
Ô If we assume the machine rental market
is perfectly competitive, no long-run
profits can be earned renting machines
± the rental rate per period ( ) will be equal to
the costs

|(?  J) dm
 Nondepreciating Machines
Ô If a machine does not depreciate, J = 0
and
/| = ?
Ô An infinitely long-lived machine is
equivalent to a perpetual bond and must
yield the market rate of return

d
 - nership of Machines
Ô irms commonly own the machines they
use
Ô A firm uses capital services to produce
output
± these services are a flow magnitude
Ô It is often assumed that the flow of
capital services is proportional to the
stock of machines
dÿ
 - nership of Machines
Ô A profit-maximizing firm facing a
perfectly competitive rental market for
capital will hire additional capital up to
the point at which the ~•
 is equal to

± under perfect competition, will reflect

both depreciation costs and the opportunity
costs of alternative investments
~•
 = = |(?J) u
 Pheory of 9nvestment
Ô If a firm decides it needs more capital
services that it currently has, it has two
options:
± hire more machines in the rental market
± purchase new machinery
Ô called investment

uc
 Present riscounted Value
Ô When a firm buys a machine, it is buying
a stream of net revenues in future
periods
± it must compute the present discounted
value of this stream
Ô Consider a firm that is considering the
purchase of a machine that is expected
to last  years
± it will provide the owner monetary returns in
each of the  years ud
 Present riscounted Value
Ô The present discounted value (
) of
the net revenue flow from the machine to
the owner is given by
  

 ë
? ( ? ) ( ? )
Ô If the
 exceeds the price of the
machine, the firm should purchase the
machine
uu
 Present riscounted Value
Ô In a competitive market, the only
equilibrium that can prevail is that in
which the price is equal to the
 of the
net revenues from the machine
Ô Thus, market equilibrium requires that

 

ë
 ë 
?  ?
  ?


u]
 Úimple Case
Ô Suppose that machines are infinitely
long-lived and the ~•
(•) is the same
in every year
Ô • = in a competitive market
Ô Therefore, the
 from machine
ownership is
  
 ë  
? ( ? ) ( ? )
u’
 Úimple Case
Ô This reduces to


 
 
>>


c ?

 ë     c>
 ?
c
 ;
?
uÚ
 Úimple Case
Ô In equilibrium


 so

;

or

ë
"

um
 General Case
Ô We can generate similar results for the
more general case in which the rental
rate on machines is not constant over
time and in which there is some
depreciation
Ô Suppose that the rental rate for a new
machine at any time is given by ( )
Ô The machine depreciates at a rate of J
u
 General Case
Ô The net rental rate of the machine will
decline over time
Ô In year the net rental rate of an old
machine bought in a previous year (Y)
would be
( ) J( Y)

uÿ
 General Case
Ô If the firm is considering the purchase of
the machine when it is new in year Y, it
should discount all of these net rental
amounts back to that date
Ô The present value of the net rental in
year discounted back to year Y is
 ?( Y) ( ) J( Y) = (?J)Y ( ) -(?J)

]
 General Case
Ô The present discounted value of a
machine bought in year Y is therefore the
sum (integral) of these present values


( ? ô  )Y ( ? ô )

(Y ) ( ) 
Y
Ô In equilibrium, the price of the machine at
time Y [|(Y)] will be equal to this present
value

|(Y )   ( ô  )Y
( ) ( ô  )

]c
Y
 General Case
Ô Rewriting, we get

 Y [ ë  

[Y A  [


[

Y

Ô
ifferentiating with respect to Y yields:

 Y [
A
 
 
[ 
[Y
 [
[

 
[Y
 Y [  
[Y

Y Y

 Y [

[ Y [ M  Y [

Y ]d
 General Case
Ô This means that
J Y[
 Y[ ë 
J[ Y[

JY
Ô J|(Y)/JY represents the capital gains that
accrue to the owner of the machine

]u
 Cutting ro n a Pree
Ô Consider the case of a forester who
must decide when to cut down a tree
Ô Suppose that the value of the tree at
any time Y is given by (Y) [where (Y)>0
and (Y)<0] and that ½ dollars were
invested initially as payments to workers
who planted the tree

]]
 Cutting ro n a Pree
Ô When the tree is planted, the present
discounted value of the owner¶s profits is

(Y) = ?Y(Y) - ½
Ô The forester¶s decision consists of
choosing the harvest date, Y, to maximize
this value
  Y

ë 
?Y Y

?
?Y Y
ë {
Y
]’
 Cutting ro n a Pree
Ô
ividing both sides by ?Y,
(Y) ± ? (Y)=0
Ô Therefore,
 (Y )
?
 (Y )
Ô ote that ½ drops out (sunk cost)
Ô The tree should be harvested when ? is
equal to the proportional growth rate of
the tree ]Ú
 Cutting ro n a Pree
Ô Suppose that trees grow according to the
equation

Y ë 4 Y

 Y 0.2
Y Y
Ô If ? = 0.0 , then Y* = 25
Ô If ? rises to 0.05, then Y* falls to 16
]m
 -ptimal •esource
Allocation -ver Pime
Ô Two variables are of primary interest for
the problem of allocating resources over
time
± the stock being allocated ()
Ô the capital stock
± a control variable () being used affect
increases or decreases in 
Ô the savings rate or total net investment
]
 -ptimal •esource
Allocation -ver Pime
Ô Choices of  and  will yield benefits
over time to the economic agents
involved
± these will be denoted ‰(,,Y)
Ô The agents goal is to maximize
P

A  

ë


{

where P is the decision time period

]ÿ
 -ptimal •esource
Allocation -ver Pime
Ô There are two types of constraints in
this problem
± the rules by which  changes over time
 
   ë 

± initial and terminal values for 
(0) = 0
(P) = P ’
 -ptimal •esource
Allocation -ver Pime
Ô To find a solution, we will convert this
dynamic problem into a single-period
problem and then show how the solution
for any arbitrary point in time solves the
dynamic problem as well
± we will introduce a Lagrangian multiplier "(Y)
Ô the marginal change in future benefits brought
about by a one-unit change in 
Ô the marginal value of  at the current time Y
’c
A Mathematical revelopment
Ô The total value of the stock of  at any
time Y is given by "(Y)
Ô The rate of change in this variable is
 
Y
  
ë
ë   
Y Y Y
Ô The total net value of utility at any time
is given by
 
H U
k c t [ k k ’d
A Mathematical revelopment
Ô The first-order condition for choosing 
to maximize is





ë
Y [



ë
ë
ë
Ô Rewriting, we get



ë 
ë
ë ë
’u
A Mathematical revelopment

Ô or  to be optimally chosen:

± the marginal increase in ‰ from increasing
 is exactly balanced by any effect such an
increase has on decreasing the change in
the stock of 

’]
A Mathematical revelopment
Ô ow we want to see how the marginal
valuation of  changes over time
± need to ask what level of  would maximize

Ô
ifferentiating with respect to :


 

Y [  
  
  
’’
A Mathematical revelopment

Ô Rewriting, we get

 U k


k k
Ô Any decline in the marginal valuation of
 must equal the net productivity of  in

either increasing ‰ or increasing 
’Ú
A Mathematical revelopment
Ô ringing together the two optimal
conditions, we have

 

 ô 
ë ë ë

H U k 
 ô ô {
k k k
Ô These show how  and " should evolve
over time to keep  on its optimal path
’m
 Ãxhaustible •esources
Ô Suppose the inverse demand function
for a resource is
|
|()
where | is the market price and  is the
total quantity consumed during a period
Ô The total utility from consumption is
ë

ë
A 



{ ’
 Ãxhaustible •esources

Ô If the rate of time preference is ?, the

optimal pattern of resource usage will
be the one that maximizes
P

A  ë 



{

’ÿ
 Ãxhaustible •esources
Ô The constraints in this problem are of
two types:
± the stock is reduced each period by the
level of consumption


Më
± end point constraints
(0) = 0
(P) = P
Ú
 Ãxhaustible •esources
Ô Setting up the Hamiltonian
  
H
e rt
U [ k k
e rt
U [ c k
yields these first-order conditions for a
maximum

  ?








 
ë
ë{
 Úc
 Ãxhaustible •esources
Ô Since ‰/ = |(),
?Y|() = "
Ô The path for  should be chosen so that
the market price rises at the rate ? per
period

Úd
9mportant Points to Note:
Ô Capital accumulation represents the
sacrifice of present for future
consumption
± the rate of return measures the terms at
which this trade can be accomplished

Úu
9mportant Points to Note:
Ô The rate of return is established
through mechanisms much like those
that establish any equilibrium price
± the equilibrium rate of return will be
positive, reflecting both individuals¶
relative preferences for present over
future goods and the positive physical
productivity of capital accumulation

Ú]
9mportant Points to Note:
Ô The rate of return (or real interest
rate) is an important element in the
overall costs associated with capital
ownership
± it is an important determinant of the
market rental rate on capital ( )

ڒ
9mportant Points to Note:
Ô uture returns on capital investments
must be discounted at the prevailing
real interest rate
± use of present value provides an
alternative way to study a firm¶s
investment decisions

ÚÚ
9mportant Points to Note:
Ô Capital accumulation (and other
dynamic problems) can be studied
using the techniques of optimal
control theory
± these models often yield competitive-
type results

Úm