Question

(25 points) 4. Answer the following three questions: a) Discuss the relationship between investment and the stock market. Hints: Discuss Tobin's q, its construction and meaning. Discuss the type of relationship that we expect to see between Tobin's q and the ratio of investment to capital, and why. b) Discuss the similarities and differences between consumption and investment decisions once expectations are considered. Hints: Suppose that households expect a transitory (non-permanent) increase in current labor income after tax, $Y_{LT} - T_t$. What would households do? What happens to $C_t$? Suppose that firms expect a transitory increase in current sales. What would firms do? What happens to $I_t$? Suppose now that households expect a permanent increase in current income. What would households do? What happens to $C_t$? 3 Finally, suppose that firms expect a permanent increase in sales. Can we presume that the change in investment spending always matches the change in sales? What variable is more volatile, $I_t$ or $C_t$ and why? c) Why do we say that consumption and investment are pro-cyclical variables? Hint: Discuss what happens to expected profitability and disposable income when output and sales decrease, and the consequences of this for $C_t$ ad $I_t$. Discuss also the case in which output and sales increase.

          (25 points) 4. Answer the following three questions:
a) Discuss the relationship between investment and the stock market.
Hints: Discuss Tobin's q, its construction and meaning.
Discuss the type of relationship that we expect to see between Tobin's q and the ratio of
investment to capital, and why.
b) Discuss the similarities and differences between consumption and investment decisions
once expectations are considered.
Hints: Suppose that households expect a transitory (non-permanent) increase in current
labor income after tax, $Y_{LT} - T_t$. What would households do? What happens to $C_t$?
Suppose that firms expect a transitory increase in current sales. What would firms do?
What happens to $I_t$?
Suppose now that households expect a permanent increase in current income. What
would households do? What happens to $C_t$?
3
Finally, suppose that firms expect a permanent increase in sales. Can we presume that
the change in investment spending always matches the change in sales? What variable is
more volatile, $I_t$ or $C_t$ and why?
c) Why do we say that consumption and investment are pro-cyclical variables?
Hint: Discuss what happens to expected profitability and disposable income when output
and sales decrease, and the consequences of this for $C_t$ ad $I_t$. Discuss also the case in
which output and sales increase.

(25 points) 4. Answer the following three questions:
a) Discuss the relationship between investment and the stock market.
Hints: Discuss Tobin's q, its construction and meaning.
Discuss the type of relationship that we expect to see between Tobin's q and the ratio of
investment to capital, and why.
b) Discuss the similarities and differences between consumption and investment decisions
once expectations are considered.
Hints: Suppose that households expect a transitory (non-permanent) increase in current
labor income after tax, YLT - Tt. What would households do? What happens to Ct?
Suppose that firms expect a transitory increase in current sales. What would firms do?
What happens to It?
Suppose now that households expect a permanent increase in current income. What
would households do? What happens to Ct?
3
Finally, suppose that firms expect a permanent increase in sales. Can we presume that
the change in investment spending always matches the change in sales? What variable is
more volatile, It or Ct and why?
c) Why do we say that consumption and investment are pro-cyclical variables?
Hint: Discuss what happens to expected profitability and disposable income when output
and sales decrease, and the consequences of this for Ct ad It. Discuss also the case in
which output and sales increase.

Added by Stanley V.

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