1Learning objectives In this chapter, you will learn: leading theories to explain each type of investmentwhy investment is negatively related to the interest ratethings that shift the investment functionwhy investment rises during booms and falls during recessions
2Types of InvestmentBusiness fixed investment: businesses’ spending on equipment and structures for use in productionResidential 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.
3PTSource: U.S. Department of Commerce. P and T denote dates of peaks and troughs, respectively.What we learn from this graph:1. Business fixed investment is the largest of the three types of investment2. Investment varies with the business cycle, rising in booms and falling in recessions.slide 3
4Understanding business fixed investment The standard model of business fixed investment: the neoclassical model of investmentShows how investment depends onMPKinterest ratetax rules affecting firms
5Two types of firmsFor simplicity, assume two types of firms:1. Production firms rent the capital they use to produce goods and services.2. Rental firms own capital, rent it out to production firms.In this context, “investment” is the rental firms’ spending on new capital goods.Note: Many students find it easier to learn the following material by separating the investment decision from the production decision. Of course, the lessons apply to real-world firms that actually do both functions.
6The capital rental market Production firms must decide how much capital to rent.Recall from chap 3: Competitive firms rent capital to the point where MPK = R/P.Kcapital stockreal rental price, R/Pcapital supplycapital demand (MPK)equilibrium rental rateThe graph of the rental market for capital is review from chapter 3. As you present it to your students, it might be worthwhile to briefly review each piece (why the supply curve is vertical, why demand = MPK).
7Factors that affect the rental price For the Cobb-Douglas production function,the MPK (and hence equilibrium R/P ) isThe equilibrium R/P would increase if:K (due, e.g., to earthquake or war)L (due, e.g., to pop. growth or immigration)A (technological improvement, or deregulation)(It might be worth reminding students that A represents the level of technology, and is a number between 0 and 1 that equals capital’s share of national income.)We use the C-D function for two reasons: First, we can make the ideas here more concrete with a specific functional form, and second, because the C-D function will be familiar to most students from earlier chapters (the appendix to Chapter 3, and the economic growth chapters).If students are wondering where the MPK equation comes from, either refer them to the Appendix to chapter 3, or, if they are acquainted with basic calculus, take the derivative of the production function with respect to K.Regarding the impact of an increase in A on R/P: We usually associate A with technology. However, A represents anything that affects the amount of output that can be produced from a given bundle of inputs. For example, firms use resources (in this context, L and/or K) to compliance with regulations (some labor time is used to fill out forms; some capital is used to reduce emissions of nasty things into the air or rivers). A relaxation of regulations would allow firms to divert these resources from compliance with regulations to production, causing output to increase. Hence, a deregulation could cause A to rise.
8Rental firms’ investment decisions Rental firms invest in new capital when the benefit of doing so exceeds the cost.The benefit (per unit capital): R/P, the income that rental firms earn from renting the unit of capital out to production firms.
9The cost of capital Components of the cost of capital: interest cost: i PK, where PK = nominal price of capitaldepreciation cost: PK, where = rate of depreciationcapital loss: PK (A capital gain, PK > 0, reduces cost of K )The total cost of capital is the sum of these three parts:Notes:Interest cost-- If firms borrow in the loanable funds market (from chapter 3) to finance their purchases of capital, then they incur interest. But even if firms use their own funds, they incur an opportunity cost equal to the interest they could have earned had they purchased Pk worth of bonds instead of spending Pk to buy a piece of capital.Depreciation cost--Remind students that is the depreciation rate, the percentage of capital that wears out each period. If the firm starts the period with $1000 worth of capital and the depreciation rate = 0.03, then at the end of the period, the value of the firm’s capital equals (1-0.03)$1000 = $970.
10Nominal cost of capital The cost of capitalNominal cost of capitalExample car rental company (capital: cars)Suppose PK = $10,000, i = 0.10, = 0.20, and PK/PK = 0.06Then, interest cost = depreciation cost = capital loss = total cost =If the price of capital, Pk, falls during the period, then firm incurs a capital loss, which increases its cost of capital.In this example, the price of capital rises, so the “capital loss” is negative. (Or, there’s a capital gain which we subtract from the cost, because the increase in the price of new capital reduces the cost of capital.)$1000$2000 $600$2400
11The cost of capital For simplicity, assume PK/PK = . Then, the nominal cost of capital equals PK(i + ) = PK(r + )and the real cost of capital equalsThe real cost of capital depends positively on:the relative price of capitalthe real interest ratethe depreciation rateThe assumption in the first line says that the price of capital rises as fast as the general price level.The real cost of capital equals the nominal cost divided by the price level, just as the real wage equals the nominal wage divided by P.
12The rental firm’s profit rate Firm’s net investment depends on the profit rate:If profit rate > 0, then it’s profitable for firm to increase KIf profit rate < 0, then firm increases profits by reducing its capital stock.(Firm reduces K by not replacing it as it depreciates)In plain English, the profit rate equals(the rental price of capital) minus (the user cost of capital)
13Net investment & gross investment Hence,where In( ) is a function showing how net investment responds to the incentive to invest.Total spending on business fixed investment equals net investment plus the replacement of depreciated capital:It might be useful to remind students that gross investment is simply net investment plus depreciation.
14The investment function An increase in rraises the cost of capitalreduces the profit rateand reduces investment:Irr2I1r1I2
15The investment function An increase in MPK or decrease in PK/Pincreases the profit rateincreases investment at any given interest rateshifts I curve to the right.IrI1r1I2
16Taxes and InvestmentTwo of the most important taxes affecting investment:Corporate income taxInvestment tax credit
17Corporate Income Tax: A tax on profits Impact on investment depends on definition of “profits”If the law used our definition (rental price minus cost of capital), then the tax doesn’t affect investment.In our definition, depreciation cost is measured using the current price of capital.But, legal definition uses the historical price of capital.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.Why the corporate income tax doesn’t affect investment when profits are defined as in the textbook: Let be the tax rate and--for this note only--let denote the profit rate as defined above. The after-tax profit rate equals (1). The firm’s investment decision depends on whether its profit rate is positive. As long as < 1, then the sign of (1) equals the sign of . I.e., if an investment project is profitable without the tax, it will be profitable (though less so) with the tax.Why using the historical price to compute depreciation understates the true cost of capital:Consider the car rental example from a few slides ago. Suppose that when the car was originally purchased, the price was only $ Then, according to the government, depreciation is only $1600 = 0.2 (the depreciation rate) times $8000 (the historical price of capital). So, according to the government, the total cost of capital is only $2000, which is $400 less than the true economic cost of capital. Thus, the government is taxing the car rental firm ( + 400) instead of .(Please forgive my use of to represent profit in this note when everywhere else we are using it to represent inflation!)
18The investment tax credit (ITC) The ITC reduces a firm’s taxes by a certain amount for each dollar it spends on capitalHence, the ITC effectively reduces PKwhich increases the profit rate and the incentive to invest.
19Tobin’s qnumerator: the stock market value of the economy’s capital stockdenominator: the actual cost to replace the capital goods that were purchased when the stock was issuedIf q > 1, firms buy more capital to raise the market value of their firmsIf q < 1, firms do not replace capital as it wears out.
20Relation between q theory and neoclassical theory described above The stock market value of capital depends on the current & expected future profits of capital.If MPK > cost of capital, then profit rate is high, which drives up the stock market value of the firms, which implies a high value of q.If MPK < cost of capital, then firms are incurring loses, so their stock market value falls, and q is low.
21The stock market and GDP Why one might expect a relationship between the stock market and GDP:1. A wave of pessimism about future profitability of capital wouldcause stock prices to fallcause Tobin’s q to fallshift the investment function downcause a negative aggregate demand shock
22The stock market and GDP Why one might expect a relationship between the stock market and GDP:2. A fall in stock prices wouldreduce household wealthshift the consumption function downcause a negative aggregate demand shock
23The stock market and GDP Why one might expect a relationship between the stock market and GDP:3. A fall in stock prices might reflect bad news about technological progress and long-run economic growth.This implies that aggregate supply and full-employment output will be expanding more slowly than people had expected.
24The stock market and GDP See Figure 17-4 on p.470 for info, source.The figure shows that the stock market and GDP tend to move together, but the association is far from precise.slide 24
25Financing constraints Neoclassical theory assumes firms can borrow to buy capital whenever doing so is profitableBut some firms face financing constraints: limits on the amounts they can borrow (or otherwise raise in financial markets)A recession reduces current profits. If future profits expected to be high, it might be worthwhile to continue to invest. But if firm faces financing constraints, then firm might be unable to obtain funds due to current profits being low.
26Residential investment The flow of new residential investment, IH , depends on the relative price of housing, PH /P.PH /P is determined by supply and demand in the market for existing houses.
27How residential investment is determined (a) The market for housingDemandSupplySupply and demand for houses determines the equilib. price of houses.The equilibrium price of houses then determines residential investment:KHStock of housing capital
28How residential investment is determined (a) The market for housing(b) The supply of new housingDemandSupplySupplyKHIHStock of housing capitalFlow of residential investment
29How residential investment responds to a fall in interest rates (a) The market for housing(b) The supply of new housingDemandSupplySupplyThe main point of this slide is to establish more formally the dependence of investment (in this case, residential investment) on the interest rate.KHIHStock of housing capitalFlow of residential investment
30The tax treatment of housing The tax code, in effect, subsidizes home ownership by allowing people to deduct mortgage interest.The deduction applies to the nominal mortgage rate,so this subsidy is higher when inflation and nominal mortgage rates are high than when they are low.Some economists think this subsidy causes over-investment in housing relative to other forms of capitalBut eliminating the mortgage interest deduction would be politically difficult.
31Inventory investment is only about 1% of GDP Yet, in the typical recession, more than half of the fall in spending is due to a fall in inventory investment.
32Motives for holding inventories 1. production smoothingSales fluctuate, but many firms find it cheaper to produce at a steady rate.When sales < production, inventories rise.When sales > production, inventories fall.
33Motives for holding inventories 1. production smoothing2. inventories as a factor of productionInventories allow some firms to operate more efficiently.samples for retail sales purposesspare parts for when machines break down
34Motives for holding inventories 1. production smoothing2. inventories as a factor of production3. stock-out avoidanceTo prevent lost sales in the event of higher than expected demand.
35Motives for holding inventories 1. production smoothing2. inventories as a factor of production3. stock-out avoidance4. work in processGoods not yet completed are counted as part of inventory.
36The Accelerator ModelA simple theory that explains the behavior of inventory investment, without endorsing any particular motive
37The Accelerator ModelNotation: N = stock of inventories N = inventory investmentAssume: Firms hold a stock of inventories proportional to their outputN = Y, where is an exogenous parameter reflecting firms’ desired stock of inventory as a proportion of output.
38The Accelerator Model Result: N = Y Inventory investment is proportion to the change in output.When output is rising, firms increase their inventories.When output is falling, firms allow their inventories to run down.
39Evidence for the Accelerator Model Inventory investment100(billions of 1996dollars)801998198419976020001999401977197420197119911993Figure 17-7 on p.478.1983-20198219751980-40-200-100100200300400500Change in real GDP (billions of 1996 dollars)
40Inventories and the real interest rate The opportunity cost of holding goods in inventory: the interest that could have been earned on the revenue from selling those goods.Hence, inventory investment depends on the real interest rate.Example: High interest rates in the 1980s motivated many firms to adopt just-in-time production, which is designed to reduce inventories.
41Chapter summaryAll types of investment depend negatively on the real interest rate.Things that shift the investment function:Technological improvements raise MPK and raise business fixed investment.Increase in population raises demand for, price of housing and raises residential investment.Economic policies (corporate income tax, investment tax credit) alter incentives to invest.
42Chapter summaryInvestment is the most volatile component of GDP over the business cycle.Fluctuations in employment affect the MPK and the incentive for business fixed investment.Fluctuations in income affect demand for, price of housing and the incentive for residential investment.Fluctuations in output affect planned & unplanned inventory investment.