Investment in an Uncertain World - Essay Example

?Investment in an uncertain world Part A. Part A (50 per cent of the marks) 1a. Consider a closed economy with households, firms and a government sector, where total current government expenditure is equal to total current revenue (from taxation). Table 1 reports data from the economy’s national accounts: (i) Calculate public expenditure as a percentage of GDP.? In a closed economy, Y = C + I + G, where Y stands for National income, C for consumption, I for investment or gross capital formation, and G for government (or public) expenditure. In this equation, because there is no foreign trade, GDP = National Income. 10,000,000 = 6,000,000 + 1,000,000 + G G = 10,000,000 – 6,000,000 – 1,000,000 = G = 3,000,000 G as a percentage of GDP = (G divided by Y) and multiplied by 100. =(3,000,000/10,000,000) *100 = = 30 per cent. (ii) Calculate households’ savings as a percentage of GDP. Explain your calculations. (6 marks) In this situation, Y = C + I + G (Savings = Investment = Gross Capital Formation) Therefore, Y = C + S + G. And S as the percentage of Y = (S/Y)* 100 = (1,000,000/10,000,000) *100 = = 0.10 * 100 = 10 per cent Therefore, households’ savings are 10 per cent of GDP. 1b. Now imagine an unexpected shock to the economy (not predicted by the majority of economists and other experts), which hits households’ confidence so that they increase their savings until these amount to 25 per cent of GDP. (i) Under Say’s Law, what is the mechanism by which firms’ investment is expected to change and what will its new value be? J. B. Say, a French classical economist, says supply creates its own demand until the equilibrium between the two is reached. By extension, Say’s law also applies to money market. When there is a glut of savings, there will be more supply of money than demand. As a result, interest rate for borrowing will come down and investment will increase. In this given case, since the savings have increased to 25 percent of GDP, investment should also increase by the same ratio of GDP. Thus, market finds the equilibrium between demand and supply for money through variations in interest rate. (ii) According to the demand-side approach, explain why firms might not necessarily adjust their investment plans. The demand-side approach argues that investors do not automatically make their investment because demand has increased. To invest, they have to be confident about the future – for the demand to sustain. Investments are often long term about which we know very little. Keynes says, ‘If we speak frankly, we have to admit that our basis of knowledge for estimating the yield 10 year hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes nothing’ (Keynes, quoted in Walsh, 2008, p. 63). In such a situation of uncertainty, the animal spirit of investors drives investors to invest. Investors wait for that spirit, which gives them confidence, to develop before they invest. This explains the fluctuation in investments and departure from the supply-demand equilibrium. For instance, in the 1999 recession, ‘the reduction in output of 1.4 per cent coincided with an 8.1 percent fall in investment’ (Trigg, 2010, p. 230). In conclusion, investors do not make adjustments in their investment plan until they are confident about making money. (iii) If firms did not change their investment plans, explain what would be the consequences for national income and how fiscal policy might be used to address this situation. (11 marks) Investment has a direct impact on national income, and fiscal policy often encourages firms to invest in order to restore the gap between savings and investment. Government expenditure is one of the key components of national income. When government increases its expenditure, national income rises; when it decreases its spending, national income also declines. Government thus can influence national income. Classical economics believes that savings and investment are equal. But people do not invest all their savings when they have no confidence about the future. For instance, banks in the United States and the United Kingdom are sitting on huge piles of cash without investing much because of the uncertainty of recovery from the 2008 recession due to high debt and high unemployment. Government can change this through fiscal policy. According to Trigg (2010, p. 242), ‘Fiscal policy involves decisions about taxation and public expenditure.’ In times of slump, government tries to increase its expenditure and reduce taxes to stimulate the economy. On the contrary, when the economy overheats, government increases taxes and reduces expenditures. Government spends in public goods and services such as roads, bridges, schools, hospitals, etc. and in providing subsidy to poor people – such as tax breaks, unemployment and other benefits. Tax breaks are given to investors to encourage them to invest. When the demand for consumption increases, it pushes up investment and national income. 1c. Now assume that the economy is open to inflows and outflows of investment, imports and exports, and has a trade deficit. (i) Define ‘trade deficit’. Trade deficit is the excess of a nation's imports of goods over its export of goods during a financial year, resulting in a negative balance of trade.   (ii) Identify a mechanism by which monetary policy could reduce this trade deficit. Trigg (2010, p. 244) says monetary policy ‘involves keeping aggregate demand and prices stable through the control of the supply of money in the economy and the setting of interest rates.’ Monetary policy helps reduce trade deficit -- the excess of imports over exports. Interest rate, which is part of monetary policy, can reduce trade deficit. A higher interest rate makes money more expensive and vice versa. By moving interest rate up, the central bank can make money more expensive, encourage savings, reduce money supply in the market and reduce demand for consumption. Consumption consists of domestic and imported products. As money becomes more expensive and the people’s consumption declines, the demand for imports is also reduced. With the reduction in imports, trade deficit shrinks. (iii) Outline one effect that a depreciation of the Pound relative to the Euro can have on UK-based investors in domestic shares and bonds. (8 marks) Currency depreciation has many effects on the economy. One of them is effect on domestic shares and bonds. The Pound’s depreciation against the Euro would bring beneficial impact for the UK economy and UK investors. Exchange rate determines the number of units of a foreign currency that exchange for one unit of home currency (Trigg, 2010, p. 250). A lower exchange rate promotes exports and higher encourages imports. When the Pound depreciates, British products will be cheaper for people living in the Euro area because a Euro will be able to buy more of the British Pounds. This will increase demand for British goods in the Euro area. With the increase in demand for British exports, investment in British industry will increase. The British firms will make profit, the value of their shares will go up, and the British investors will benefit from higher stock prices and higher profits. The impact of depreciation on bonds, which are guaranteed loan instruments, tend to just the opposite. When the stock prices go up, investors switch their investment to stocks, which are more profitable and more risky, and reduce their bond portfolio. Thus, the Pound’s depreciation against the Euro will have different impact on investors in shares and in bonds. 2. In 2006, Brad, who follows the markets with great interest and excitement, invested ?10,000 in a share-based unit trust. Table 2 shows the subsequent investment returns and the forecast returns for 2011–12. 2a. Calculate the expected value of the forecast returns for 2011–12. Based on your answer, why might Brad’s financial adviser suggest he sell these shares? (3 marks) Based on the information in the table, the expected value of the forecast returns for 2011-12, using the weighted average, will be as follows: 0.6 * 10 + 0.4 * -20 = 6 – 8 = -2% Since the investment has made a loss of 5% in 2010-11 and the 2011-12 forecast is also negative (-2%), the financial adviser might advise Brad to sell his shares and by other shares. 2b. Since Brad has received good returns in the past he decides to continue holding his unit trust investment. (i) Explain to what extent his approach could be rational and relate your answer to one or more forms of the efficient market hypothesis. Efficient market hypothesis (EMH) assumes that markets are ‘efficient in the sense of immediately and accurately incorporating all relevant information’ (Shipman, p. 190). But that does not always happen. That is why some traders make profit and others do not in the same market. So, Brad’s decision to retain his unit trust investment could turn out to be rational in some situations. Brad’s decision to retain his unit trust shares will have to meet two conditions to be rational. First, he must have better information than others that the unit trust’s fundamentals – assets, balance sheet, yield potential, etc. -- are strong and point to profit in the long run. This comes as an exception to the semi-strong form of EMH, which rejects fundamental analysis. Second, Brad should have inside information about the unit trust doing something to boost profits – such as acquiring a profitable firm, selling itself to a profitable firm, launching new products, etc. This would be an exception to the strong form of EMH that suggests even insider information would trickle out to the market to be incorporated in the trade. In these situations, Brad’s decision could prove rational in the long run. (ii) Briefly describe two behavioural traits his reasoning may reveal. (10 marks) Brad receives a bonus from his employer, as he has helped secure the company’s good results in the middle of a rather depressed economy. The amount of the bonus is ?1000 and the rate of inflation is forecast to be 5 per cent over the coming year. He has two options: .  Strategy 1: he could deposit the bonus in a savings account (offering a 2% nominal AER). .  Strategy 2: he could buy shares in his company (predictions suggest that the shares would yield a return of 5% with a probability of 0.80 and a return of -10% with a probability of 0.20). ?2c. Compare the expected value of the two strategies. Explain: The expected value of strategy 1 at the end of the year without counting the inflation: 0 EV = (Principal + interest on savings account) =1000 + (2/100 * 1000) = 1000 + 20 = EV = ?1020 The expected value of strategy 2; = ?1000 + (5 * 0.8/100) + (-10 * 0.2/100) = 000 + 40 – 20 = EV =?1020 The expected value is the same in both strategies. ?(i) which strategy Brad might choose if he is risk averse; 0 A risk-averse Brad will choose strategy 1 and deposit the bonus in his savings account. ?(ii) which strategy he might choose if he is risk-seeking; A risk-seeking Brad will choose strategy 2 and invest his bonus in shares. (iii) bearing in mind your answer at 2a, how choosing either strategy might be interpreted as a display of narrow framing (mental accounting) behaviour? (12 marks) Narrow framing and mental accounting often determine investment decisions. Brad will likely decide whether he deposits the money in his savings account or buys shares based on it. Mazzucato (2010, p. 291) defines narrow framing as a situation in which investors tend to focus on the short term even when their investments are long term. Mental accounting describes the propensity of investors to put financial decisions into mental categories in which they tend to stay and keep their stocks even when they are making losses hoping that there will be a recovery. If he is risk-averse and if he has had a bad experience with stocks, Brad might decide to put his bonus of ?1000 in his savings account. Otherwise, he might invest in stocks offering higher risks and rewards. Part B. 3. Using the extract below by Lou Basenese, consider how the growth of green energy might conform with the stages of a bubble defined by Kindleberger. To what extent could investors benefit from this potential bubble? (50 marks) Bubble is the inflation of an asset price, eventually reversed by a sudden burst or a prolonged decline (Muzzacato, 2010, p. 262). Some people believe that a green energy bubble is in the making, but there is not enough proof just yet for it. However, if a green energy bubble builds, it will likely follow Kindleberger’s stages and give early investors in green energy huge profits. Llewellyn (n.d.) says, ‘People buy simply because they believe that everybody else is going to buy. You get what is called a bandwagon effect and from time to time, you then get a situation where prices go far too high, and that is really what we call a bubble.’ Basenese (2009) is one of those who believe that a bubble is building in the green energy sector – solar, bio-fuel, wind, hydropower, etc. He points to three ingredients of a bubble: Cash as the fuel, legislation as the accelerant and popular culture as the kicker. Together they contribute to speculative investment, which leads to a bubble that will eventually burst. He suggests, since all three elements exist in the effort to develop green energy, a bubble is coming. As a proof, Basenese (2009) quotes Eric Janszen, a former venture capitalist, who has said the unprepared investors might go into the red as much as by $21 trillion in the green energy bubble. He cites the following reasons as to why he thinks a green energy bubble coming: 1.  The legislation is in place. And more is on the way. Under the Bush administration we got the ridiculous ethanol mandates. And solar and wind credits were routinely extended. Now, President Obama is making the environment and green-collar jobs the cornerstones of his economic recovery plan. 2.  Money is already pouring into the sector. More than $200 billion was invested in clean energy and clean technology markets in the last two years. And yet, record amounts of cash are still waiting to be deployed. According to Bloomberg, speculators are sitting on $8.85 trillion in cash, desperate for an outlet. 3.  Tough credit conditions actually encourage more speculation. Wayne Woo, director of Good Energies, reports that green start-ups will now give up to 75% ownership (up from 50%) to get their projects off the ground. Getting a bigger piece of the potential profit pie, for the same perceived level of risk, is bound to encourage more speculation. 4.  Green is the new black. Forget fashionable. Going green resembles a religious movement nowadays. This alone has people ignoring economics in the name of social responsibility. Jackson (n.d.) seems to agree. He says, ‘One of the things that we’re seeing at the moment is the green bubble. If you come along with a half-good green idea, there’s a good chance in technology that you’d get funded. I suspect that there’s a bit of fad there. A little mini bubble which might need looking at.’ Undoubtedly, investment in green energy is growing respectably, thanks to increasing environmental awareness and decreasing fossil fuel reserves. By Basenese’s account, $200 billion was invested in this sector last year. However, Basenese makes several assumptions that are unlikely to hold. First, the $8.85 trillion on which, as he says, speculators have will not necessarily go to green energy alone. Biotechnology, another hot sector, and others could compete for this cash. Second, political situation is far from favourable for a green energy bubble, as the United States and several developing countries are reluctant to reduce carbon emission due to high cost. Third, green energy is a small sub-sector of the huge energy sector. Therefore, there is no basis to believe that a green energy bubble is in the making. However, if and when a green energy bubble develops, it will likely follow the stages Kindleberger has described. Kindleberger (cited in Mazzucato, 2010) describes five stages of bubble – displacement, credit creation, euphoria, critical stage/financial distress, and revulsion. An external shock (technological or institutional) creates opportunity for profit. This leads to the creation of credit and buying euphoria that drive the economy to financial distress and collapse. Kindleberger’s first stage has already occurred with the arrival of green technology prompted by increasing environmental awareness and declining fossil fuel reserves. But the second stage of credit creation has not occurred yet, and the subsequent stages will not come until the second stage has come along. If the green energy sector picks up as the next big sector, investors will rush to it with great euphoria, leading to over-investment, distress and revulsion. Bubble or no bubble, investors can hugely benefits from an investment boom in the green energy sector. Green energy revolution will be the next frontier of prosperity, as industrial and information technology revolutions have been in the past. To sum, there is no reason to believe yet that a green energy bubble is building. When the bubble comes along, it will most likely follow Kindleberger’s five stages. Bubble or no bubble, green energy boom will offer investors great opportunities for innovation and profit. Works Cited Basenese, L., 2009, Green energy: The largest speculative bubble we’ve ever seen, The Oxford Club, issue #947 [online] Available at [Accessed 23 September 2010]. Jackson, M., n.d., Bubbles transcript. [online] Available at [Accessed 20 August 2011.] Kindleberger, C., 1989, Maniacs, panics and crashes: A history of financial crises, 2nd ed. London: Macmillan Llewellyn, D, n.d., Bubbles transcript. [online] Available at < …> [Accessed 20 August 2011]. Mazzucato, M., 2010, Bubbles and investment behaviour. In: M. Mazzukato, J. Lowe, A. Shipman, and A. Trigg (ed.) Personal investment: Financial planning in an uncertain world, Basingstoke: The Open University. Chapter 6. Shipman, A., 2010, Markets and players. In: M. Mazzukato, J. Lowe, A. Shipman, and A. Trigg (ed.) Personal investment: Financial planning in an uncertain world, Basingstoke: The Open University. Chapter 4. Trigg, A, 2010, Economic Fluctuations. In: M. Mazzukato, J. Lowe, A. Shipman, and A. Trigg (ed.) Personal investment: Financial planning in an uncertain world, Basingstoke: The Open University. Chapter 5. Walsh, J., 2008, Keynes and the market. New Jersey: Wiley Read More