basic theory of investment - will invest if present value of future profits exceeds cost  

• depreciation - determines how long machine will last
  • depreciation rate (d) - how much less useful a machine gets after a year
• V(Pt)= Pt+1 / (1+rt) + Pt+2(1-d) / [(1+rt)(1+rt+1)] + ...
  • V = present value of expected profits (P)
  • this model assumes that there are no profits in the first year and doesn't start depreciating until after year 1
• It = I( V(Pt) )
  • simple model
  • investment depends positively on expected present value of future profits
• assume constant interest and profits (static expectations)
  • Pt+2 = Pt+1 = Pt
  • rt = rt+1
  • V(Pt) = Pt / (rt+d)
  • user cost (rental cost of capital) - rt+d
  • each year company would charge real interest and amount that machine will depreciate for use of machine (at the very least)

current profit vs expected future profit  

• investment strategies change according to current profit, not just expected
• relation between future expected profits and current profits
• low current profit >> firms less willing to borrow to buy new machines, even if expected profits are high
  • lenders also reluctant to give money to firm w/ low profits
• It = I(V(Pet) , Pt)
  • investment depends positively on both expected present value of future profits and current level of profit

profit and sales - determined by level of sales and capital stock  

• Pt = P(Yt/Kt)
• for constant sales, higher capital stock >> lower profit
• for constant sales, lower capital stock >> higher profit

volatility of consumption vs investment  

• consumption, investment usually move together
• w/ income increase (positive IS shift), consumption increases at most 1 to 1
  • increase consumption more than income increase >> would have to cut consumption later
• increase in investment can be greater than increase in sales
  • company moves quickly >> large, short investment spending increase
  • higher investment >> higher capital stock (K) >> Y/K goes back to normal >> investment goes back to normal