Money & Banking:
ABCT Simulation
This simulation involves making production, investment and debt decisions in order to maximize
a firm’s “wealth creation” at the end of a ten year period where these decisions are made every
three months. The purpose of the simulation is to illustrate some of the principles of the
Austrian Business Cycle Theory. [Wealth Creation = Distributed profits + net worth]
Structure of the Simulation
The simulation takes place over ten years, with decisions being made each quarterly period. You
will have to decide on the production level, the investment level and whether to borrow funds
(and how much to borrow). At the end of each decision you will receive information on the
market price of your product. [Your firm is what we call a “price taker,” meaning that your
production decision cannot affect the market price.] With this you can calculate your revenues,
profits and cash holdings. Your cash holdings must be positive in order to make a decision for
the next period, otherwise your business will shut down. Every four periods (i.e., annually) you
will calculate the present value of your firm’s expected net worth for the end point of the
simulation. Part of your score on this simulation will depend on your final net worth relative to
the other participants in the simulation.
Choose a level of production
You begin with a maximum level of production of 1 million units. You can produce at any of
eight different levels of production or you can shut down completely, and you will make this
decision in each period. Your revenues over the next period will depend not only on the level of
output you’ve chose, but also on the market price, about which you can only form an
expectation. To help in this regard you will have information on prices in past periods as well as
an assortment of macroeconomic data. Your costs of production will consist of a fixed cost
(which is constant no matter how much you produce) and a variable cost.
Your fixed costs are as follows: $3 million when maximum production is 1 million units, $4
million when maximum production is 1.2 million and $5.5 when maximum production is 1.5
million. The maximum production will be determined by the level of investment you make, as
described in the next section. If you shut down production, you will continue to incur these
fixed costs for four moves (one year). At that point your firm will have completely collapsed.
The average variable cost per unit produced is shown in the table (on the next page) for the
differing levels of production you can choose, from 100% down to zero.
For example if the maximum production is 1 million units and if you are producing at the 80%
level (800,000 units), then your total variable cost is $8 million (800,000*$10). Since your fixed
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 1 of 8
costs are $3 million then your total cost is $11 million. If your product sells for $18, then your
revenues are $14.4 million. Consequently, your profit for this period would be $3.4 million.
Production
100%
95%
90%
80%
70%
60%
40%
20%
0%
AVC
$11.50
$11.00
$10.50
$10.00
$9.50
$9.00
$10.00
$11.00
0
This table will be constant across different maximum levels of
production. That is, regardless of what your maximum level of
production is, your AVC at 80%, for example, will always be $10
per unit. Your maximum production level can change over time
based on your level of investment, which is the other variable you
must decide on for each period.
Choose a level of investment
You will have four investment choices – no investment, minimum investment, low investment
and high investment.
No Investment - If you skip the minimum necessary investment to maintain your capital stock,
your production limit will fall by 10% over each of the next four periods. That is, by the fourth
period you will only be able to produce at, or below, 60% of your maximum. It will then decline
by 20% over the next two periods and, three periods later you will have to shut down
production. That is, by the 7th period of no investment, enough capital will have deteriorated
such that you can’t produce anything. You can restore higher production limits only by making
the minimum investment, following the same pattern in reverse. For example, if you didn’t
make this investment for four periods and your production limit is now 60%, if you start making
this investment each period, your production will rise to 70% the next period, then to 80% after
that, and so on.
Minimum Investment - This is what you must spend to maintain your capital stock. In other
words, this is just sufficient to cover your depreciation and to maintain your maximum level of
production. This minimum investment is $1 million if your maximum production is 1 million
units, $1.2 million for 1.2 million units and $1.5 million for 1.5 million units. [These are on a per
period/move basis.] Even if you opt for the low or high investment outcome, you must still
explicitly make this minimum investment.
Low Investment - This option will cost you $3 million in each of four consecutive periods.
Starting with the fifth period, your maximum production will be 20% higher (i.e., 1,200,000
units). This will last for 16 periods (4 years) and then fully depreciate. That is, you go back to
having a maximum production level of 1 million units. If you want to continue this higher level,
then you would need to reinvest $3 million per period starting four periods before the maximum
falls back to 1 million. Note that your minimum investment will rise starting with the fifth
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 2 of 8
period, when this new, higher, production level comes on line. Failing to make this minimum
investment will have the consequences described above. Also, note that over the time span
where the maximum production level is higher, so too will be your fixed costs.
What does this investment earn you? Since you can produce more, you can earn more revenue
(which will depend on the price) and since your average variable costs are linked to the
percentage level of maximum output, over most reasonable ranges of production your AVC will
fall. On the other hand, your fixed costs and minimum capital investment cost will rise. To
determine whether the investment is worthwhile you will need to find its net present value,
meaning that you will need an interest rate that applies. At the beginning of the simulation the
relevant market rate of interest is 6%.
If you start making these investments and then pause, you will have to make an additional
investment for each period you stopped. For example, if you make two payments (@$4 million)
and then stopped for one period, you would have to make three more continuous payments in
order to reach the higher maximum production.
High Investment - This option will cost you $7 million in each of four consecutive periods.
Starting with the fifth period, your maximum production will be 50% higher (i.e., 1,500,000
units). This will last for 20 periods (five years) and then fully depreciate. That is, you go back to
having a maximum production level of 1 million units. If you want to continue this higher level,
then you would need to reinvest $7 million per period starting four periods before the maximum
falls back to 1 million. Note that your minimum investment will rise starting with the fifth
period, when this new, higher, production level comes on line. Failing to make this minimum
investment will have the consequences described above. Also, note that over the time span
where the maximum production level is higher, so too will be your fixed costs.
What does this investment earn you? Since you can produce more, you can earn more revenue
(which will depend on the price) and since your average variable costs are linked to the
percentage level of maximum output, over most reasonable ranges of production your AVC will
fall. On the other hand, your fixed costs and minimum capital investment cost will rise. To
determine whether the investment is worthwhile you will need to find its net present value,
meaning that you will need an interest rate that applies. At the beginning of the simulation the
relevant market rate of interest is 6%.
If you start making these investments and then pause, you will have to make an additional
investment for each period you stopped. For example, if you make two payments (@$10
million) and then stopped for one period, you would have to make three more continuous
payments in order to reach the higher maximum production.
What if you are currently producing at 1,200,000 and want to raise your production to
1,500,000? Instead of requiring a $7 million investment in each of four consecutive quarters you
will only have to make an $5 million investment (over four consecutive periods).
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 3 of 8
Borrowed funds
Investment activities that raise your productive capacity must be financed with borrowed funds.
Additionally, you must borrow funds to cover temporary losses over and above your current
cash holdings. The rate of interest you must pay and the length of time to repay the bonds
depends on the amount you want to borrow. The table below show this information for the
situation where the Federal Reserve has set a target federal funds rate of interest of 2.0%.
You can only borrow in million dollar amounts as
shown in the table (and no more than $10 million
in any one quarter). Since each period is three
months, each effective period interest rate is
simply one-quarter of the annual rate as shown
in the last column.
Also note that another interest rate will be
determined and that is the rate at which you can
lend your cash balances (see below) in the
commercial paper market.
Equal principal payments are made each period
plus the accrued interest on the outstanding
balance. For example, borrow $4 million, to be
paid back over two years (8 periods). Principal payments are $500,000 per period and the period
interest is 0.875% (=3.5%/4). So, the first payment is [$500,000 + ($4 million * 0.875%)] =
$500,000 + $35,000 = $535,000. The second period payment would be $500,000 + ($3.5 million *
0.875%) = $530,625 and so on. [The final payment, made in the 8th quarter, would be $504,375.]
Cash Balances
The firm can lend out its cash balances at the rates given. They can do this for balances over $5
million. The firm must distribute any balances over $30 million to its shareholders. For example,
if a firm has $20 million in cash at the start of a quarter, and the interest rates shown above
apply, then it can earn 0.475% (1.9/4) on $15 million of it. If, at the end of the year it has $38
million in cash, $8 million must be distributed to the shareholders.
Shutting Down
If your firm shuts down production, either because you were forced
to or you chose to, you will incur fixed costs for four more periods,
unless we are in the last year of the simulation. In that case, you will
incur fixed costs through the remaining periods and this must be
subtracted, along with any remaining debt outstanding, from your
cash balance to get your final net worth.
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 4 of 8
The Decision Sheet you will be filling out in class:
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 5 of 8
Calculating the NPV for investment decision – an example:
Here, assume the low investment option, with prices at $22 and operating at 100% (so, AVC is
$11.50). Ignore the quarterly issue here and convert everything into annual terms. So, over the
course of a year the firm produces an additional 800,000 units, generating additional expected
revenue of $17.6 million. A similar analysis is done for costs – the fixed costs rise by $4 million
per year; the minimum investment for this larger facility will require an additional $800,000 per
year and the additional variable costs will be $9.2 million per year if the facility is operating at
100%. If the relevant market rate of interest is 6%, then this project has a net present value of
$447,528.
What is the correct interest rate to use for this procedure? We will take the current interest rate
for a $5 million loan as the relevant market rate of interest for discounting. [That rate will
change as the target federal funds rate changes over the course of the simulation.]
Year:
1
2
3
4
5
+Q
0
800,000
800,000
800,000
800,000
E(P)
-$22
$22
$22
$22
E(+TR)
-$17,600,000 $17,600,000 $17,600,000 $17,600,000
+FC
-$4,000,000 $4,000,000 $4,000,000 $4,000,000
+min I
-$800,000
$800,000
$800,000
$800,000
+VC @ 100%
-$9,200,000 $9,200,000 $9,200,000 $9,200,000
TC
-$14,000,000 $14,000,000 $14,000,000 $14,000,000
Inv. cost -$12,000,000
Net income -$12,000,000 $3,600,000 $3,600,000 $3,600,000 $3,600,000
interest
6.0%
6.0%
6.0%
6.0%
6.0%
NPV
-$11,320,755 $3,203,987 $3,022,629 $2,851,537 $2,690,129
Sum of NPV
$447,528
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 6 of 8
Group:
Investment decision for year: ___
Fill out this form whenever you make an investment decision:
There are six years listed here to cover the “high investment” case. If doing the “low
investment” then you will only need figures for 5 years, as with the example above.
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 7 of 8
Debt Schedule (example):
Here is the debt schedule for one particular spectrum of interest rates – when the Federal
Reserve targets the federal funds rate at 2.0%.
ECO473 – Money & Banking (Foster)
Business Cycle Simulation (2.0)
Page 8 of 8