Review of the Previous
Lecture
• Business Fixed Investment
– Stock Market and Tobin’s q
– Financing Constraints
• Residential Investment
Topics under Discussion
• Residential Investment (cont.)
• Inventory Investment
– Seasonal Fluctuations and Production
Smoothing
– Accelerator Model of Inventories
– Inventories and Real interest Rate
• Money Supply
– 100% Reserve Banking
– Functional Reserve banking
Residential Investment
We will now consider the determinants of
residential investment by looking at a simple
model of the housing market.
Residential investment includes the purchase of
new housing both by people who plan to live in
it themselves and by landlords who plan to rent it
to others.
To keep things simple, we shall assume that all
housing is owner-occupied.
Residential Investment
There are two parts to the model:
1) The market for the existing stock of
houses determines the equilibrium
housing price
2) The housing price determines the flow of
residential investment.
Residential Investment
• The relative price of housing adjusts to
equilibrate supply and demand for the existing
stock of housing capital.
• Construction firms buy materials and hire labor
to build the houses and then sell them at
market price.
• Their costs depend on the overall price level P
while their revenue depends on the price of
houses PH.
• The Higher the PH, the greater incentive to build
house.
Residential Investment
Market for Housing Supply of New Housing
Relative PH/P
Price S
of housing
PH/P
Stock of housing capital, KH Flow of residential investment, IH
Residential Investment
• This model of residential investment is much
similar to q theory of business fixed investment,
which states that business fixed investment
depends on the market price of installed capital
relative to its replacement cost, which in turn
depends on expected profits from owning installed
capital
• The residential investment depends on the relative
price of housing, which in turn depends on demand
for housing, depending on the imputed rent that
individuals expect to receive from their housing
Residential Investment
• When the demand for housing shifts, the
equilibrium price of housing changes, and
this change in turn affects residential
investment.
• An increase in housing demand, perhaps
due to a fall in the interest rate, raises
housing prices and residential investment.
Residential Investment
Market for Housing Supply of New Housing
Relative PH/P
Price S
of housing
PH/P
D’
D
Stock of housing capital, KH Flow of residential investment, IH
Inventory Investment
• Inventory investment, the goods that
businesses put aside in storage, is at the
same time negligible and of great
significance.
• It is one of the smallest components of
spending, yet its volatility makes it critical in
the study of economic fluctuations.
• In recession, firms stop replenishing their
inventory as goods are sold, and inventory
investment becomes negative.
Reasons for Holding
Inventories
1. When sales are high, the firm produces less
that it sells and it takes the goods out of
inventory. This is called production
smoothing.
2. Holding inventory may allow firms to operate
more efficiently. Thus, we can view
inventories as a factor of production.
Reasons for Holding
Inventories
3. Also, firms don’t want to run out of goods when
sales are unexpectedly high. This is called
stock-out avoidance.
4. Lastly, if a product is only partially completed,
the components are still counted in inventory,
and are called, work in process.
Seasonal Fluctuation and
Production Smoothing
• Contrary to the expectations of many economists
and researchers, firms do not use inventories to
smooth production over time.
• The clearest evidence comes from industries with
seasonal fluctuations in demand. e.g. fan
manufacturing. One would expect that firms would
build up inventories in times f low sales and draw
them down in times of high sales.
• Yet in most industries firm do not use inventories to
smooth production over the year, rather seasonal
pattern matches seasonal pattern in sales.
The Accelerator Model of
Inventories
The accelerator model assumes that firms hold
a stock of inventories that is proportional to the
firm’s level of output.
When output is high, manufacturing firms need
more materials and supplies on hand, and more
goods in process of completion.
When Economy is booming, retail firms want to
have more merchandise on their shelves to
show customers.
The Accelerator Model of
Inventories
• Thus, if N is the economy’s stock of inventories
and Y is output, then
N=Y
where is a parameter reflecting how much
inventory firms wish to hold as a proportion of
output.
• Inventory investment I is the change in the
stock of inventories N.
• Therefore,
I = N = Y
The Accelerator Model of
Inventories
The accelerator model predicts that inventory
investment is proportional to the change in output
• When output rises, firms want to hold a larger
stock of inventory, so inventory investment is high
• When output falls, firms want to hold a smaller
stock of inventory, so they allow their inventory to
run down, and inventory investment is negative.
The model says that inventory investment
depends on whether the economy is speeding up
or slowing down.
Inventories and the Real
Interest Rate
• Like other components of investment,
inventory investment depends on the real
interest rate.
• When a firm holds a good in inventory and
sells it tomorrow rather than selling it today,
it gives up the interest it could have earned
between today and tomorrow.
• Thus, the real interest rate measures the
opportunity cost of holding inventories.
Inventories and the Real
Interest Rate
• When the interest rate rises, holding
inventories becomes more costly, so
rational firms try to reduce their stock.
• Therefore, an increase in the real interest
rate depresses inventory investment.
Summary
• Residential Investment
• Inventory Investment
– Seasonal Fluctuations and Production
Smoothing
– Accelerator Model of Inventories
– Inventories and Real interest Rate
Upcoming Topics
• Money Supply
– A closer Look at Money Creation
– A Model of Money Supply
– Instruments of Money Supply
• Money Demand
– Theories of Money Demand
