Econ 2003 Chapter 17

• Investment


  Businesses' spending on equipment and structures for use in production, purchases of new housing units, and the value of the change in inventories of finished goods, materials and supplies, and work in progress
• In this chapter, you will learn:
• Three types of investment

  • Business fixed investment
  • Residential investment
  • Inventory investment
• Business fixed investment


  Businesses' spending on equipment 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 work in progress
• U.S. Investment and its components, 1970–2011
• Neoclassical model of investment

  Shows how investment depends on marginal product of capital, interest rate, and tax rules affecting firms
• Two types of firms

  • Production firms (rent the capital they use to produce goods and services)
  • Rental firms (own capital, rent it to production firms)
• Capital rental market


  Production firms rent capital to the point where marginal product of capital equals the real rental price
• Factors that affect the rental price
• Rental firms' investment decisions


  Rental firms invest in new capital when the benefit (rental income) exceeds the cost (interest, depreciation, and capital loss)
• Cost of capital


  Interest cost, depreciation cost, and capital loss
• Example of cost of capital calculation for a car rental company
• Net investment


  Depends on the firm's profit rate - if positive, firm increases capital stock, if negative, firm reduces capital stock
• Gross investment


  Total spending on business fixed investment, equal to net investment plus replacement of depreciated capital
• Increase in real interest rate

  Raises the cost of capital, reduces the profit rate, and reduces investment
• Increase in marginal product of capital or decrease in relative price of capital


  Increases the profit rate and increases investment at any given interest rate
• Corporate income tax


  Discourages investment by overstating profits due to using historical rather than current prices of capital
• Investment tax credit


  Reduces the effective price of capital, increasing the profit rate and the incentive to invest
• Tobin's q


  Ratio of the stock market value of the economy's capital stock to the actual cost to replace that capital
• Tobin's q > 1

  Firms buy more capital to raise the market value of their firms
• Tobin's q < 1


  Firms do not replace capital as it wears out
• Decline in stock prices

  Reduces household wealth, shifts the consumption function down, causes a negative aggregate demand shock
• Efficient markets hypothesis
• Keynes's "beauty contest"


  Stock prices reflect people's views about what other people think will happen to stock prices, not just rational valuation
• Financing constraints
• Residential investment


  Depends on the relative price of housing, determined by supply and demand in the market for existing houses
• Fall in interest rates

  Increases demand for housing, shifts the supply of new housing to the right, increasing residential investment
• Inventory investment
• Motives for holding inventories

  • Production smoothing
  • Inventories as a factor of production
  • Stock-out avoidance
  • Work in process
• High real interest rates


  Motivate firms to adopt just-in-time production to reduce inventories
• Credit crunch


  Helps cause a huge drop in inventory investment as firms purchase inventories using credit
• Investment is the most volatile component of GDP over the business cycle
• Fluctuations in employment, income, and output affect the incentives for different types of investment