Exam 6: Chinas Path of Investment

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a. Using the above equation: 1/PE = (1 ? .25)(.04 + .01) + .005 + .035+ .02 ? .03
we have PE = 14.8.
b. One Scenario:
1/ 30= (1-0) (.0655+0) + .001 + .045 + .04 -implies = 11.8 % for a very long time. This would be faster than we expect nominal GDP to rise for a prolonged period, so it seems too optimistic. In this sense, it must be based on adaptive expectations.
c. in a nutshell, we have a short run supply which is vertical but a long run supply with some elasticity. If demand grows rapidly we get caught first on the short run curve (A) but eventually prices settle down to the long run curve (B).
Renting is not a perfect substitute for a home. When you buy a home in many cities you may get two very important things: A hukou and a bride. You will likely not get these if you rent in an urban area in China.

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If most output is consumption we can value that pretty easily; at the margin its value is worth what a consumer pays for the product or service when purchased. Investment goods are trickier - especially in China. Purchases of investment goods (like a new building) are often between "related parties" or government controlled entities and we are not fully confident that what is paid for these investment goods reflect true value. In the case of investment goods, we only understand its value as it yields benefits over many decades. Ideally, those benefits would be to consumers for sake of measurement. But if the benefits are too more users of investment, we are sort of "kicking the can down the road." Thus, when half of a country's GDP is devoted to investment, we can measure that in a quantity sense, but are measurement may misprice in terms of quality or true value.

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a. (from Macro Finance Insight 6.1):
which yields
$P \times \mathrm{MPK}=\text { rental cost of capital or } r$
Here, $M P K$ can be defined as the increment to perpetual cash flow from an increase in one unit of capital today. Investment as $\Delta K$ , and assuming a perpetually level cash flow that can increase as a result of in capital. Thus we have:
$\mathrm{NPV}=-\Delta K+\sum_{l}^{\infty} \frac{C F(K)_{i}}{(1+r)^{i}}=-\Delta K+\frac{C F(K)}{r}$
To maximize, with respect to $\mathrm{K}$ , we set
$\Delta(\mathrm{NVP}) / \Delta K=0$
which yields
$0=-1+[\Delta \mathrm{CF}(K) / \Delta K] / r$ b. There are really two issues (questions) here. Firstly, is the model relevant to all sectors in China? Secondly, if it is relevant are the costs and returns market based or are they distorted due to some form of financial repression (non-market controls in financial markets)? For the first question, those sectors which are non-government (private companies and entrepreneurs) which make up about 2/3 of all investment probably do use such a model. The second question though relates to the complex structure of China's financial markets, which remain segmented between favored borrowers (often with government ties) and non-favored borrowers. The latter use a cost of capital that is artificially high, the former a cost of capital that is artificially low.
c. Investment yields value in the future. Since such a large part of the economy is devoted to investment, we want to be sure that society's scarce resources (savings) are not being wasted.