Monetary Policy Actions and the Incentive to Invest: The "Value of Waiting" May Overwhelm Low Interest Rates

By Emmons, William R.; Schmid, Frank A. | Business Economics, April 2004 | Go to article overview

Monetary Policy Actions and the Incentive to Invest: The "Value of Waiting" May Overwhelm Low Interest Rates


Emmons, William R., Schmid, Frank A., Business Economics


The ability of monetary policy actions to affect the private sector's incentive to invest in fixed capital is hotly debated. Whereas a downward shift in the yield curve increases the present value of expected cash flows and should spur investment, lower short-term interest rates make delay more desirable. These influences work against each other, so the net effect of stimulative monetary policy actions could go either way. This article outlines a simple investment decision rule that captures both effects of changing interest rates. It also clarifies why monetary policy actions that shift the yield curve may or may not affect fixed investment.

**********

Many economists and policymakers consider business fixed investment ("fixed private nonresidential investment" in the national accounts) to be an important transmission channel for monetary policy actions. Moreover, business fixed investment may be a leading economic indicator. Although business fixed investment accounted for only 9 to 14 percent of GDP in any quarter between 1960 and 2003, it accounted for about 24 percent of GDP growth during the two years following the recessions of 1969-70 and 1981-82. Also, declines in business investment spending typically lead the economy into recession, most recently during late 2000 in advance of the 2001 recession.

The decision to invest depends critically on the opportunity cost of capital--that is, the rate at which future cash flows are discounted. For given cash flow expectations, the lower the cost of capital, the more potential investment projects are profitable and hence should be implemented. Although the Federal Reserve does not exert direct control over the cost of capital, monetary policy may affect the incentive to invest in important ways. This article adapts a recently developed model to highlight the complex link between monetary policy actions and the private sector's incentive to invest.

The Net Present Value Rule

The simple textbook net present value (NPV) rule states that a given project should be undertaken if (and only if) its NPV--that is, the sum of its discounted cash flows--is positive. The project's NPV is calculated as

(1) NPV = [T.summation over (t=1)] [[C[F.sub.t]]/[(1+k)[.sup.t]]],

where k is the (marginal) opportunity cost of capital and the CF are (point estimates of uncertain) end-of-period incremental cash flows (i.e., in excess of the firm's existing cash flows, some of which may be crowded out by the new project).

The marginal cost of capital, k, should reflect only the market-related--that is, systematic--risk of the project (rather than the firm). It is merely an extension of the Modigliani-Miller theorem to say that the "risk that is relevant in computing a project's cost of capital is the risk of the project's cash flows and not the risk of the financing instrument (e.g., stocks, bonds) the firm issues to finance the project." This is why there is no uniform value for the cost of capital of a given company. In fact, companies "should adopt a policy of using different costs of capital, at least at the divisional level" (Bodie and Merton 2000).

Although the NPV rule generally is correct in a static world, it is by now well-known that it does not always give the correct answer from a dynamic perspective (that is, when there are multiple decision points). The NPV rule might lead to an inefficient investment decision if projects available today can be delayed until tomorrow. If a project can be delayed, it might be worthwhile to wait even if the NPV of undertaking the project today is positive. Such a situation arises if the value of waiting is higher than the NPV of starting the project today, possibly because the marginal cost of capital, k, is likely to be lower tomorrow. In other words, there might be value in waiting to undertake business fixed investment even if the project is currently profitable.

A positive value of waiting exists only where investment is irreversible and where, at the same time, uncertainty about a parameter pertinent to the investment decision will be resolved at a future date.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Monetary Policy Actions and the Incentive to Invest: The "Value of Waiting" May Overwhelm Low Interest Rates
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.