Investment Three types of investment

ƒ leading theories to explain each type of ƒ Business fixed investment:

investment businesses’ spending on equipment and
structures for use in production.
ƒ why investment is negatively related to the
interest rate ƒ Residential investment:
purchases of new housing units
ƒ things that shift the investment function (either by occupants or landlords).
ƒ why investment rises during booms and falls ƒ Inventory investment:
during recessions the value of the change in inventories
of finished goods, materials and supplies,
and work in progress.
slide 0 slide 1

U.S. Investment and its components, Understanding business fixed

1970-2009
investment
Billions 2400
Total investment
of 2005 2200
Business fixed
ƒ The standard model of business fixed
dollars 2000 investment:
1800 investment
Residential investment
1600 Change in the neoclassical model of investment
inventories
1400
1200
ƒ Shows how investment depends on
1000 ƒ MPK
800
ƒ interest rate
600
400 ƒ tax rules affecting firms
200
0
-200
1970 1975 1980 1985 1990 1995 2000 2005 slide
2010
2 slide 3

Two types of firms The capital rental market

real rental
ƒ For simplicity, assume two types of firms: Production firms
price, R/P capital
must decide how supply
1. Production firms rent the capital they use
much capital to rent.
to produce goods and services.
2. Rental firms own capital, rent it to Recall from Chap. 3:
production firms. Competitive firms capital
rent capital to the demand
point where (MPK)
In this context,
MPK = R/P. equilibrium
“investment” is the rental firms’ rental rate K
spending on new capital goods. K capital
stock

slide 4 slide 5

1
 Factors that affect the rental price Rental firms’ investment decisions

For the Cobb-Douglas

Y = A K α L1−α ƒ Rental firms invest in new capital when the
production function,
benefit of doing so exceeds the cost.
the MPK (and hence R ƒ The benefit (per unit capital):
= MPK = α A (L K )
1−α
equilibrium R/P ) is P R/P, the income that rental firms earn
R/P
from renting the unit of capital to
The equilibrium R/P would increase if:
production firms.
ƒ ↓K (e.g., earthquake or war)
ƒ ↑L (e.g., pop. growth or immigration)
ƒ ↑A (technological improvement, or deregulation)

slide 6 slide 7

The cost of capital The cost of capital

Components of the cost of capital: Nominal cost ⎛ ∆P ⎞
= i PK + δ PK − ∆PK = PK ⎜ i + δ − K ⎟
interest cost: i ×PK, of capital
⎝ PK ⎠
where PK = nominal price of capital Example: car rental company (capital: cars)
depreciation cost: δ ×PK, pp
Suppose PK = $ , i = 0.10,, δ = 0.20,,
$10,000,
,
where δ = rate of depreciation and ∆PK/PK = 0.06
capital loss: − ∆PK
Then, interest cost = $1000
(a capital gain, ∆PK > 0, reduces cost of K )
depreciation cost = $2000
The total cost of capital is the sum of these
capital loss = − $600
three parts:
total cost = $2400
slide 8 slide 9

The cost of capital The rental firm’s profit rate

For simplicity, assume ∆PK/PK = π. A firm’s net investment depends on its profit rate:

R P P
Then, the nominal cost of capital equals Profit rate = − K ( r + δ ) = MPK − K ( r + δ )
PK(i + δ − π) = PK(r +δ ) P P P
PK ƒ If profit rate > 0,
and the real cost of capital equals (r + δ )
P then increasing K is profitable
The real cost of capital depends positively on: ƒ If profit rate < 0, then the firm increases profits by
ƒ the relative price of capital reducing its capital stock.
ƒ the real interest rate (Firm reduces K by not replacing it as it depreciates.)
ƒ the depreciation rate
slide 10 slide 11

2
 Net investment & gross investment The investment function

Hence, I = I n ⎣⎡MPK − (PK P )( r + δ ) ⎦⎤ + δ K

net investment = ∆K = I n ⎡⎣MPK − (PK P )( r + δ )⎤⎦

An increase in r r
where In[ ] is a function that shows how ƒ raises the cost
net investment
i responds
d to the
h iincentive
i to iinvest. off capital
it l
ƒ reduces the r2
Total spending on business fixed investment equals
profit rate
net investment plus replacement of depreciated K: r1
ƒ and reduces
gross investment = ∆K + δ K investment:
= I n ⎡⎣MPK − (PK P )( r + δ ) ⎤⎦ + δ K I2 I1 I

slide 12 slide 13

The investment function Taxes and investment

I = I n ⎣⎡MPK − (PK P )( r + δ ) ⎦⎤ + δ K
Two of the most important taxes
An increase in MPK affecting investment:
r
or decrease in PK/P
1. Corporate income tax
ƒ increases the
profit rate 2. Investment tax credit
ƒ increases
investment at any r1
given interest rate
ƒ shifts I curve to I1 I2 I
the right.
slide 14 slide 15

Corporate Income Tax: A tax on profits The Investment Tax Credit (ITC)
Impact on investment depends on definition of “profit”
ƒ The ITC reduces a firm’s taxes by a certain
ƒ In our definition (rental price minus cost of capital),
amount for each dollar it spends on capital.
depreciation cost is measured using current price of
capital, and the CIT would not affect investment ƒ Hence, the ITC effectively reduces PK
ƒ But,
But the legal definition uses the historical price of
which increases the profit rate and the incentive
capital.
to invest.
ƒ If PK rises over time, then the legal definition
understates the true cost and overstates profit,
so firms could be taxed even if their true economic
profit is zero.
Thus, corporate income tax discourages investment.
slide 16 slide 17

3
 Relation between q theory and
Tobin’s q
neoclassical theory described above
Market value of installed capital Market value of installed capital
q = q =
Replacement cost of installed capital Replacement cost of installed capital
ƒ numerator: the stock market value of the economy’s ƒ The stock market value of capital depends on the
capital stock. current & expected future profits of capital.
ƒ denominator: the actual cost to replace the capital ƒ If MPK > cost of capital, then profit rate is high,
goods that were purchased when the stock was which drives up the stock market value of the firms,
issued. which implies a high value of q.
ƒ If q > 1, firms buy more capital to raise the market ƒ If MPK < cost of capital, then firms are incurring
value of their firms. losses, so their stock market values fall, so q is low.
ƒ If q < 1, firms do not replace capital as it wears out.
slide 18 slide 19

The stock market and GDP The stock market and GDP

Reasons for a relationship between the Reasons for a relationship between the
stock market and GDP: stock market and GDP:
1. A wave of pessimism about future 2. A fall in stock prices would
profitability
p y of capital
p would ƒ reduce household wealth
ƒ cause stock prices to fall ƒ shift the consumption function down
ƒ cause Tobin’s q to fall ƒ cause a negative aggregate demand
ƒ shift the investment function down shock
ƒ cause a negative aggregate demand
shock

slide 20 slide 21

The stock market and GDP The stock market and GDP

Reasons for a relationship between the Percen 50 Stock prices (left 10 Percen
t scale) t
stock market and GDP: 40
8
change change
30
3. A fall in stock prices might reflect bad from 6
from
1 year 20 1 year
g
news about technological p
progress
g and earlier
earlier
li 10 4
long-run economic growth.
0 2
This implies that aggregate supply and
-10
full-employment output will be expanding 0
-20
more slowly than people had expected. -2
-30 Real GDP (right
-40 scale) -4
1970 1975 1980 1985 1990 1995 2000 2005 2010
slide 22 slide 23

4
 Alternative views of the stock market: Alternative views of the stock market:
The Efficient Markets Hypothesis Keynes’s “beauty contest”
ƒ Efficient Markets Hypothesis (EMH): ƒ Idea based on newspaper beauty contest in which
The market price of a company’s stock is the fully a reader wins a prize if he/she picks the women
rational valuation of the company, most frequently selected by other readers as
given current information about the company’s most beautiful.
business prospects.
ƒ Keynes proposed that stock prices reflect people’s
ƒ Stock market is informationally efficient: views about what other people think will happen to
each stock price reflects all available information stock prices; the best investors could outguess
about the stock.
mass psychology.
ƒ Implies that stock prices should follow a random
walk (be unpredictable), and should only change
ƒ Keynes believed stock prices reflect irrational
waves of pessimism/optimism (“animal spirits”).
as new information arrives.
slide 24 slide 25

Alternative views of the stock market:

Financing constraints
EMH vs. Keynes’s beauty contest

Both views persist. ƒ Neoclassical theory assumes firms can borrow to

buy capital whenever doing so is profitable.
ƒ There is evidence for the EMH and random-walk
theory (see p.498).
ƒ But some firms face financing constraints:
limits on the amounts they can borrow
ƒ Yet, some stock market movements do not (or otherwise raise in financial markets).
seem to rationally reflect new information. ƒ A recession reduces current profits.
If future profits expected to be high,
investment might be worthwhile.
But if firm faces financing constraints and current
profits are low, firm might be unable to obtain funds.
slide 26 slide 27

How residential investment is

Residential investment
determined
(a) The market for housing
ƒ The flow of new residential investment, IH , PH Supply Supply and demand for
depends on the relative price of housing PH /P. P houses determines the
ƒ PH /P determined by supply and demand in the equilib. price of houses.

market for existing houses.

The equilibrium price of
houses then determines
residential investment:
Demand
KH
Stock of
housing capital
slide 28 slide 29

5
 How residential investment is How residential investment responds
determined to a fall in interest rates
(a) The market for housing (b) The supply of new housing (a) The market for housing (b) The supply of new housing
PH Supply PH PH Supply PH
P P P P
Supply Supply

Demand Demand
KH IH KH IH
Stock of Flow of residential Stock of Flow of residential
housing capital investment housing capital investment
slide 30 slide 31

U.S. Housing Prices and Housing Starts,

2000-2008 The tax treatment of housing
180 2,500
ƒ The tax code, in effect, subsidizes home ownership
by allowing people to deduct mortgage interest.
Housing Starts (tthousands)

160
= 100 in 2000 1st quarter

2,000
ce Index

140 ƒ The deduction applies to the nominal mortgage rate,

120 so this subsidy is higher when inflation and nominal
1,500
,
Housing Pric

mortgage rates are high than when they are low.

100

80 Housing 1,000 ƒ Some economists think this subsidy causes

prices over-investment in housing relative to other forms of
60 Housing
(left scale) capital
starts (right 500
40 scale) ƒ But eliminating the mortgage interest deduction
20 0 would be politically difficult.
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
slide 32 slide 33

Inventory investment Motives for holding inventories

1. production smoothing
Inventory investment is only about Sales fluctuate, but many firms find it cheaper to
1% of GDP. produce at a steady rate.
Yet, in the typical recession, ƒ When
Wh sales
l < production,
d ti iinventories
t i rise.
i
more than half of the fall in spending ƒ When sales > production, inventories fall.
is due to a fall in inventory investment.

slide 34 slide 35

6
 Motives for holding inventories Motives for holding inventories

1. production smoothing 1. production smoothing

2. inventories as a factor of production 2. inventories as a factor of production
Inventories allow some firms to operate more 3. stock-out avoidance
efficiently.
ffi i tl
To prevent lost sales when demand is higher
ƒ samples for retail sales purposes than expected.
ƒ spare parts for when machines break down

slide 36 slide 37

Motives for holding inventories The Accelerator Model

1. production smoothing
A simple theory that explains
2. inventories as a factor of production
the behavior of inventory investment,
3. stock-out avoidance without endorsing
4. work in process any particular motive

Goods not yet completed are counted in

inventory.

slide 38 slide 39

The Accelerator Model The Accelerator Model

ƒ Notation: Result:
N = stock of inventories ∆N = β ∆Y
∆N = inventory investment Inventory investment is proportional to the
ƒ Assume: change in output.
Firms hold a stock of inventories proportional ƒ When output is rising,
to their output firms increase inventories.
N = β Y, ƒ When output is falling,
where β is an exogenous parameter firms allow their inventories to run down.
reflecting firms’ desired stock of inventory
as a proportion of output.
slide 40 slide 41

7
 Evidence for the Accelerator Model Inventories and the real interest rate
Inventory 100
investment
80
1998 1984 ƒ The opportunity cost of holding goods in
(billions of
1967 1978 inventory: the interest that could have been
1996 60
dollars) earned on the revenue from selling those goods.
40
1974 1996
2004
ƒ Hence,
Hence inventory investment depends on
20
the real interest rate.
0
1983 ƒ Example:
-20
1982 High interest rates in the 1980s motivated many
2001
-40 firms to adopt just-in-time production, which is
-200 -100 0 100 200 300 400 500 designed to reduce inventories.
Change in real GDP (billions of 1996 dollars)
slide 42 slide 43

Chapter Summary Chapter Summary

1. All types of investment depend negatively on the 3. Investment is the most volatile component of GDP
real interest rate. over the business cycle.
2. Things that shift the investment function: ƒ Fluctuations in employment affect the MPK and
the incentive for business fixed investment.
ƒ Technological improvements raise MPK and
raise business fixed investment. ƒ Fluctuations in income affect demand for, price of
housing and the incentive for residential
ƒ Increase in population raises demand for, price
investment.
of housing and raises residential investment.
ƒ Fluctuations in output affect planned & unplanned
ƒ Economic policies (corporate income tax,
inventory investment.
investment tax credit) alter incentives to invest.

slide 44 slide 45