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

Article excerpt

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.

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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. …