(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 $C_t$?
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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.
