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MACROECONOMICSMACROECONOMICS

2010 Worth Publishers, all rights reserved 2010 Worth Publishers, all rights reserved

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PowerPointPowerPointSlides by Ron CronovichSlides by Ron Cronovich

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C H $ P T EC H $ P T E

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Invest%entInvest%ent

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Modified for EC 204by Bob Murphy


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In this chapter, you will learn:In this chapter, you will learn:

leading theories to explain each type ofinvestment

why investment is negatively related to the

interest rate things that shift the investment function

why investment rises during booms and falls

during recessions


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3CHAPTER 18 nvestment

Three types of investment

Business fixed investment!businesses" spending on e#uipment and

structures for use in production$

Residential investment!purchases of new housing units

%either by occupants or landlords&$

Inventory investment!

the value of the change in inventories

of finished goods' materials and supplies'

and wor( in progress$


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!S! Investment an" its components,#$%&'(&&$

Billionsof 200)

dollars

Total investmentBusiness fixed investment

Residential investment

Change in inventories


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)CHAPTER 18 nvestment

n"erstan"in) *usiness +e"

investment

*he standard model of business fixedinvestment!

the neoclassical model of investment

+hows how investment depends on! MPK

interest rate

tax rules affecting firms


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,CHAPTER 18 nvestment

Two types of +rms

-or simplicity' assume two types of firms!

.$ Production firms rent the capital they use

to produce goods and services$

2$ Rental firms own capital' rent it toproduction firms$

In this context,investment is the rental firms

sending on ne! caital goods"


7/43/CHAPTER 18 nvestment

The capital rental mar-et

roduction firms

must decide how

much capital to rent$

1ecall from Chap$ 3!Competitive firms

rent capital to the

point where

MPK R#P$(

capitalstoc(

real rentalprice' R)P capital

supply

capitaldemand%MPK&

e$uili%riumrental rate


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.actors that a/ect the rental price

-or the Cobb5ouglasproduction function'

the MPK%and hence

e#uilibrium R#P & is

*he e#uilibrium R#P would increase if!

K &e"g", earth$ua'e or !ar(

L &e"g", o" gro!th or immigration(

A &technological imrovement, or deregulation(


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Rental +rms0 investment "ecisions

1ental firms invest in new capital when thebenefit of doing so exceeds the cost$

*he benefit %per unit capital&!

R/P' the income that rental firms earnfrom renting the unit of capital to

production firms$


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.0CHAPTER 18 nvestment

The cost of capital

Components of the cost of capital!

interest cost) iPK'

where PK nominal price of capital

dereciation cost) PK'

where rate of depreciation

caital loss) PK

%a capital gain' PK7 0' reduces cost of K &

*he total cost of capital is the sum of these

three parts!


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..CHAPTER 18 nvestment

*hen' interest cost

depreciation cost

capital loss

total cost

The cost of capital

Example: car rental company %capital! cars&

+uppose PK 8.0'000' i 0$.0' 0$20'and PK9PK 0$0,

:ominal costof capital

8.000

82000

8,00

82400


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The cost of capital

-or simplicity' assume PK9PK $

*hen' the nominal cost of capital e#uals

PK%i ; & PK%r;&

and the real cost of capital e#uals

*he real cost of capital depends positively on!

the relative price of capital

the real interest rate

the depreciation rate


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The rental +rm0s pro+t rate

< firm"s net investment depends on its profit rate!

f profit rate 7 0'then increasing K is profitable

f profit rate = 0' then the firm increases profits by

reducing its capital stoc(%i"e"' not replacing capital as it depreciates&


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Net investment 1 )ross investment

>ence'

where In* + is a function that shows hownet investment responds to the incentive to invest$

*otal spending on business fixed investment e#uals

net investment plus replacement of depreciated K!


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.)CHAPTER 18 nvestment

The investment function


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.,CHAPTER 18 nvestment

The investment function


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./CHAPTER 18 nvestment

Taes an" investment

*wo of the most important taxes

affecting investment!

.$ Corporate income tax2$ nvestment tax credit


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.CHAPTER 18 nvestment

Corporate Income Ta: A ta on

pro+tsmpact on investment depends on definition of ?profit$@

n our definition %rental price minus cost of capital&'

depreciation cost is measured using current price

of capital' and the C* would not affect investment

But' the legal definition uses the historical price ofcapital$

f PKrises 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 Aero$

*hus' corporate income tax discourages investment$


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The Investment Ta Cre"it 2ITC3

*he *C reduces a firm"s taxes by a certainamount for each dollar it spends on capital$

>ence' the *C effectively reduces PK

which increases the profit rate and the incentiveto invest$


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To*in0s 4

numerator! the stoc( mar(et value of the

economy"s capital stoc($ denominator! the actual cost to replace the capital

goods that were purchased when the stoc( was

issued$

f q 7 .' firms buy more capital to raise the mar(et

value of their firms$

f q = .' firms do not replace capital as it wears out$


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2.CHAPTER 18 nvestment

Relation *etween 4 theory an"

neoclassical theory "escri*e" a*ove

*he stoc( mar(et value of capital depends on the

current expected future profits of capital$ f MPK7 cost of capital' then profit rate is high'

which drives up the stoc( mar(et value of the firms'

which implies a high value of q$

f MPK= cost of capital' then firms are incurring

losses' so their stoc( mar(et values fall' so qis low$


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The stoc- mar-et an" 567

Reasons for a relationshi %et!een thestoc' mar'et and *+P)

.$< wave of pessimism about future

profitability of capital would! cause stoc( prices to fall

cause *obin"s $ to fall shift the investment function down cause a negative aggregate demand shoc(


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2$< fall in stoc( prices would!

reduce household wealth shift the consumption function down

cause a negative aggregate demand shoc(


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3$< fall in stoc( prices might reflect bad news

about technological progress and longruneconomic growth$

*his implies that aggregate supply and full

employment output will be expanding moreslowly than people had expected$


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ercentchange

from. year

earlier

ercentchangefrom. yearearlier

Real *+P &right scale(

toc' rices &left scale(


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2,CHAPTER 18 nvestment

Alternative views of the stoc- mar-et:

The E8cient Mar-ets 9ypothesis

Efficient ar!ets Hypot"esis #EH$%*he mar(et price of a company"s stoc( is the fullyrational valuation of the company'given current information about the company"s

business prospects$

+toc( mar(et is informationally efficient!each stoc( price reflects all available information

about the stoc($ mplies that stoc( prices should follow a random

&al!%be unpredictable&' and should only changeas new information arrives$


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2/CHAPTER 18 nvestment

Alternative views of the stoc- mar-et:

eynes0s ;*eauty contestigh interest rates in the .60s

motivated many firms to adopt Iustintimeproduction' which is designed to reduceinventories$

nventories and credit conditions

Many firms purchase inventories using credit$

Example! *he credit crunch of 20006 helpedcause a huge drop in inventory investment$$


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Chapter SummaryChapter Summary

.$


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Chapter SummaryChapter Summary

3$ nvestment is the most volatile component ofG5 over the business cycle$

-luctuations in employment affect the M and

the incentive for business fixed investment$

-luctuations in income affect demand for' priceof housing and the incentive for residentialinvestment$

-luctuations in output affect planned unplanned inventory investment$

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