Overview Of Tobin's Theory Of Investment

Tobin’s Theory, named after the economist who developed it, is centered around a variable named q, which is equal to the ratio between the market value of a given company and its replacement cost of capital. A q value greater than 1 signals the fact that the market is taking into consideration a series of assets (usually intangible) which are not reflected in the company’s financial statements and is an evidence of the positive perception of the market regarding the company’s capacity to generate added value. Similarly, a q value that is smaller than 1 indicates the market’s lack of confidence regarding the company’s ability to generate added value and, implicitly, a satisfactory financial profit. A high value of the q variable has a positive impact on investments, as a big market capitalization with respect to the replacement cost of capital indicates that the company is in a position to issue equity at a price that is high in relation with the cost of acquiring new equipment, thus making this an advantageous action, with a direct impact on the general growth of investments within the economy.

On the other hand, a small q value shows that the acquisition of companies that have among their assets similar equipment and production factors is a more profitable course of action than buying new ones, so the level of investment is negatively affected (and with it the level of production) due to the increased activity on the mergers and acquisitions market rather than spending for new equipment. Once the notion of the q variable is clarified, we can proceed to study the place that Tobin’s concept has within the monetary policy transmission mechanism.

Tobin’s theory describes the mechanism of the effect of a change in monetary policy and the subsequent reaction in asset prices (for example equities, shares and other securities), which influences the real economy. It explains how a growth in asset prices may influence investment. In the case of a loosening of monetary policy (low interest rates) equity prices will grow (a preference of investment on the capital market over deposits in the banking sector), whereby the market value of firms is increased in comparison with the acquisition costs (this ratio is measured by the Tobin coefficient – q = the market value of a firm / the costs for renewing the capital). This situation gives enterprises the stimulus to subscribe new shares at a higher price, where they use the capital gained in this way for purchasing capital goods. The transmission mechanism of monetary policy pursuant to this theory functions as follows: in consequence of a fall in interest rates equity prices increase, which subsequently brings about a growth in the market value of the firm in proportion to the costs for renewing capital and an increase in capital expenditure in consequence of which economic activity increases and output grows.