Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Macroeconomics Chamberlin and Yueh Chapter 3 Lecture.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Investment Theories of Fixed Business Investment Optimal Capital Stock Model Tobin’s q Inventory Investment Residential Investment Credit Rationing and Investment

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Learning Objectives Defining investment and its three main components Using the optimal capital stock model to explain changes in business investment Constructing Tobin’s q as a forward-looking model of business investment Identifying the factors that are responsible for inventory investment Understanding the main determinants of residential investment Explaining how the supply of investment finance can determine aggregate investment

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning What is investment? Private investment represents additions to the nation’s capital stock. Investment is important because it plays a dual role in the economy. First, it is part of aggregate demand, so it enters the circular flow of income and determines output movements in the short run. Second, by augmenting the nation’s stock of productive assets, investment is central to the determination of long run economic growth.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning The Importance of Investment Although investment expenditures constitute a much smaller part of aggregate demand than consumption, the pace and pattern of business investment is central to the understanding of economic activity. Investment is much more volatile than both consumption and GDP. Also, investment is often seen to be a leading indicator of GDP, meaning that changes in investment predict future movements in output. Empirical evidence leads us to believe that investment may be an important factor in accounting for business cycles.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Components of Private Investment The three main components of private investment: fixed business investment, residential investment, and changes in the stock of inventories.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Theories of Fixed Business Investment There are two major models of note, which share very similar foundations. The optimal capital stock model argues that firms have a desired level of capital stock and investment simply acts to move the current capital stock in that direction. The second is known as the q theory of investment (or Tobin’s q). When investment is undertaken, most returns are accrued in the future; therefore, the decision to invest must be forward-looking. As stock markets value firms according to their expected future cash flows, an important feature of q theory is the linking of investment decisions to stock market prices.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Capital Stock Model Also referred to as the Neoclassical model of investment. The model argues that firms will settle on an optimal level of capital stock, which is where profits are maximised. Investment is then determined implicitly; it is the required additions or reductions to the capital stock that move it from its current to its optimal level.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Capital Stock Model Profit maximisation is the key to the investment decision. Firm profits are calculated in the conventional way: as total revenue minus total costs. Total revenue is found by multiplying the output of the firm (Y) by the price at which it is sold (P):

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Optimal Capital Stock Model The relationship between a firm’s output and its inputs of capital is described by a production function: A common assumption is that the production function experiences diminishing returns to capital.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Marginal Product of Capital The marginal product of capital (MPK) tells us how total output changes when the capital stock changes by one unit: As the production function displays diminishing returns to capital, it must be the case that the marginal product of capital (MPK) falls as the installed capital stock rises.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Marginal Revenue Product of Capital Given that total revenue will be given by, the change in total revenue following a change in capital stock will be given by the marginal revenue product of capital (MRPK). The MRPK can be thought of as the value of an extra unit of capital.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Costs The cost of purchasing K units of capital is given by P K K. This is made up of the price of a unit of capital, P K, and the total units installed, K. However, the firm does not buy the capital itself, but rents it from capital leasing firms at the rental rate of r. This rental rate can simply be thought of as the interest rate.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Costs Therefore, the total cost of installing K units of capital is: The marginal cost of capital is the cost of installing one extra unit of capital stock: This cost is constant and does not change with the amount of capital stock already installed.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Profit Maximisation Given the costs and revenues involved in installing capital, the firm can work out the size of the capital stock that would maximise its profits:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Profit Maximisation Profits will be maximised at the level of capital stock where the marginal revenue product of capital is equal to the marginal cost, or the optimal level of capital stock: It is only at the optimal level of capital stock where there is no incentive for the firm invest or disinvest.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Firm Investment Having established the optimal capital stock, this model predicts that firm investment will be given by a simple relationship: Investment is determined implicitly by the firm seeking to move their capital stock towards its optimal level.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning What factors affect investment? If all firms were at their optimal (profit maximising) level of capital stock, then what factors would lead to a change in investment? This simple model argues that anything which leads to a change in the level of the optimal capital stock will induce investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Price of output Changes in the price of output would have a similar effect as changes in productivity. The total revenue curve would again shift upwards and the marginal revenue product of capital schedule will shift outwards. The consequence will once again be that the optimal capital stock will be higher, thereby encouraging firm investment. This might account for some of the pro-cyclical nature of investment. When the economy is performing well, aggregate demand may be strong which supports higher prices and encourages investment. Likewise, in a recession, low demand could lead to poor sales and discounted prices, discouraging investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Role of government policy The cost of capital can be adjusted to reflect the presence of taxes and subsidies: A tax on capital implies that. Consequently, the optimal capital stock and investment will both fall following an increase in these taxes. However, a subsidy,, would have the opposite effect and could be used to encourage investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Interest rate changes Interest rates will affect capital in entirely the same way as the changes in the prices of capital goods. The interest rate is seen as the opportunity cost of capital, instead of investing in capital goods there is always the possibility of saving in the bank. Therefore, changes in the interest rate will imply changes in the rental rate of capital.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Criticisms of the Optimal Capital Stock Model The model is not forward-looking, so it does not allow any room for investment to be determined by expectations. Second, the capital stock is assumed to always change instantaneously to its new optimal level. These were incorporated into the theory, Tobin’s q.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Tobin’s q In its most simplest of guises, Tobin’s q can be written as follows: q = Market Value of Firm / Replacement Cost of Installed Capital. The market value of a firm is determined by the expected discounted future cash flows that it will generate. The replacement cost of installed capital is simply the price of purchasing that firm’s capital stock. Tobin’s q is just the ratio of the two. Therefore, changes in q will lead to changes in investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Tobin’s q If q>1, then every £1 of installed capital would create more than £1 in market value. Installed capital is more valuable than uninstalled capital so investment would be positive. When q=1, every £1 of installed capital will create an additional £1 of market value. In this case, installed and uninstalled capital has the same value and investment would be zero. Finally, if q<1, then uninstalled capital is more valuable than installed capital. Investment would be negative; a firm would be able to achieve more by selling its physical capital than it would lose in market value.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Stock Markets and Investment If it is the stock market that represents the value of a firm, then it is not surprising to expect a linkage between the stock market and investment. Changes in the value of stock markets should be positively correlated with future changes in investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Evidence of Tobin’s q There does appear to be some correlation between movements in the stock market and investment. However, the evidence supporting this relationship is by no means clear cut. This may be for a number of reasons. First, not all firms are quoted on the stock market. A significant amount of investment is undertaken by these firms, so this would dilute any potential relationship between stock prices and investment. Second, stock market valuations may be determined by factors other than fundamentals related to a firm’s future cash flows. It is widely recognised that stock markets tend to be fairly volatile.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Tobin’s q and the Market Value of the Firm The market value of the firm is given by the sum of its expected discounted future cash flows. The revenue the firm generates in each period is given as before:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Tobin’s q and the Market Value of the Firm The value of the firm at the present time is given by the present discounted value of all future revenues: The cost of the initially installed capital stock is also as before:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Rewriting Tobin’s q Tobin’s q = Further simplifying, if we continue to assume that capital depreciation is zero, then the capital stock will be durable and the same in all periods, so:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Rewriting Tobin’s q Tobin’s q The same factors that cause a change in investment in the optimal capital stock model are likely to cause a change in investment in the q-based model. Investment is likely to rise if productivity or output prices rise, or the interest rate falls – these factors will lead to an increase in the market value of the firm. A fall in the cost of capital goods would also encourage investment. The main feature added by q-based models is that current investment will also be influenced by the future values of these variables.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Adjustment Costs What factors might account for the speed at which this investment takes place? The analysis so far has assumed that the marginal cost of changing the capital stock is simply given by the price of a unit of physical capital. The firm may also face costs in installing or uninstalling capital, which increase with the size of the investment. It is much more expensive to make large wholesale changes to the capital stock then just small fine-tuning changes. Installation costs will increase with the rate of investment. Also, installation costs are transitory; once the capital is installed no further costs are levied. The presence of these installation or adjustment costs suggests that it would be optimal to make small changes to the capital stock.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Tobin’s q Adding this insight to the q-theory enables us to write down a rule that determines investment: Investment will increase when q>1 and fall when q<1. The parameter reflects installation costs. As these rise, investment will respond more gradually.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Inventory Investment There are several reasons why firms may hold inventories. Holding stocks of inventories would allow firms to smooth production. Changes in inventories act as a shock absorber to fluctuations in demand. Production smoothing would be the most efficient way of organising production. Production smoothing would act to minimise these costs. Secondly, holding inventories would enable the firm to avoid stock outs. This is where the firm has to turn away customers because it has no stock to sell. Clearly, stock outs would be poor for revenue.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Production Smoothing and the Pro-cyclicality of Inventory Investment The main rationale for smoothing production is to reduce average total cost over time/the economic cycle. A firm’s total cost function is assumed to be convex. Convexity implies that the marginal cost of an extra unit of output increases with the level of output. The convexity of the total costs curve is sufficient reason to use inventories to smooth production.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Production smoothing The benefits of production smoothing are directly related to the convexity of the total cost curve. The more convex, the larger the gains from production smoothing. Instead, if the total cost function was linear (so it is no longer strictly convex), then the gains from production smoothing would completely disappear. Linear total costs imply constant marginal costs at all levels so there are no gains to smoothing production. The cost gains from smoothing production need to be weighed against the costs of storing inventories. As storage costs become more significant, the pro-cyclicality of inventory investment will increase. This is because the cost gains from production smoothing are low because marginal costs are fairly constant, or because storage costs are relatively high so as to offset the cost savings from smoothing production.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Accelerator Model of Investment The accelerator model could apply to most types of investment, but it is particularly relevant to inventory investment. It states that inventory investment is likely to be highly pro-cyclical. If firms hold stocks of inventories proportional to output, then:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Accelerator Model of Investment Changes in output would lead to proportional changes in the stock of inventories: Therefore, inventory investment will respond positively to changes in output:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Evidence Empirical evidence supports the accelerator model. A clear positive correlation exists between economic growth and inventory investment. The observed pro-cyclicality of investment tends to reject the production smoothing model. It is argued that inventory investment fits the accelerator model better than the other components of investment. The reason for the stronger pro-cyclical movement of inventories is most likely due to the fact that there are few installation costs involved with adding to the stock of inventories. Therefore, this investment will respond much more spontaneously to changes in output than fixed business investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Residential Investment Residential investment refers to expenditure on improving existing dwellings or building new ones. The factors which determine residential investment should conceivably share a common structure with the q-theory explaining fixed business investment. Recall that according to the q-theory, a firm will invest if expected discounted value of the cash flows generated by that investment exceeds the cost of the physical capital required.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Residential Investment A house is an asset, so its value should reflect the future discounted value of rents that it earns. Just because a house might be owner-occupied does not mean that this principle no longer applies. Strictly speaking, the owner is also the tenant, so would in effect just be paying rent to himself which would be a needless transaction. However, there is still an implicit rental value involved.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Residential Investment The current value of a house,, should be determined by the discounted value of the future rents that it will earn:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Residential Investment If the rent is the same in all periods, then The physical cost of building a house is given by the construction price, P H.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Residential Investment Therefore, a q-theory for housing investment would take the following form:

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning q theory of residential investment Where q theory fits residential investment well is incorporating adjustment costs. Adding to the stock of houses is a timely business, and therefore it is expected that residential investment will respond slowly to changes in house prices. Housing investment will respond positively to the rental value of housing, and negatively with the interest rate and the costs of construction. Also, the pace of investment is likely to be influenced by installation costs connected to building houses. The rental value of housing may be determined by several factors. The most likely is of course income or unemployment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Credit Rationing and Investment A significant proportion of investment is undertaken using borrowed funds, this view implies that financial markets are always prepared to lend sufficient funds to satisfy investment demand. Once it is accepted that the supply of investment loans might not be perfectly elastic, the supply side might become an important determinant of aggregate investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Imperfect Information Financial markets aim to intermediate between savers and borrowers, but this role is beset with problems of imperfect information. A firm borrowing to invest knows far more about the risks and returns of the investment project than the financial institution providing the finance. This scenario where one party in a debt contract has superior information to the other is known as asymmetric information.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Asymmetric Information Moral Hazard: When a debt contract between borrowers and lenders allows for bankruptcy, it increases the incentive of the borrower to undertake risky investments. If high risk investments come to fruition, then they offer high returns to the borrower; but, if they fail then the borrower can avoid repayment by declaring bankruptcy. Adverse Selection: This explains why a lender may prefer to ration credit rather than increase the interest rate. Risk- averse investors who undertake relatively safe but lower return projects will be driven out of the loans market by an increase in interest rate. Therefore, as the interest rate increases, the lender is left with a higher proportion of riskier investments in their loan portfolios.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Effects on loans The first order effect of an increase in interest rates is to increase the supply of loans. This is because every loan made by a financial institution achieves a higher rate of return so the credit supply curve is upward sloping. The second order effect though considers the impact of an increase in interest rates on the quality of loans. Firstly, moral hazard implies that as the interest rate increases the marginal investment project undertaken becomes more risky. In order to accept a loan at a higher interest rate, the project undertaken needs to offer a higher rate of return and therefore is likely to be riskier. Adverse selection implies that as the interest rate continues to increase, those undertaking safer but lower return investments will be driven out of the market. Consequently, a point is reached where interest rate increases reduce the expected returns from loans due to deterioration in the quality of loans made.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Implications of asymmetric information At low rates of interest the first order effect dominates, so an increase in interest rates leads to an increase in the supply of loans. However, there is a critical level of interest rates where the second order effect begins to dominate and further increases in interest rates reduce loan supply. This is because at higher rates the quality of the loan portfolio declines as it comes to be made up of increasingly risky loans. As a result, the expected returns of the loan portfolio will fall when the interest rate surpasses this critical level and the loan supply curve becomes backward bending. Financial institutions would therefore be unwilling to advance loans beyond the level. This shows how asymmetric information produces the credit rationing result. The availability of finance can be just as important as the cost of finance as a determinant of investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning What factors affect the availability of credit? The supply constraint is determined by the critical level of interest rate, where the credit supply schedule becomes backward bending. Therefore, anything which alters the shape of the supply curve is likely to have an effect on the level at which credit rationing becomes relevant. There are strong grounds for arguing that the availability of finance will be driven in large part by the same factors that determine the demand for investment. Adverse changes in the investment climate, due to any of the factors mentioned previously in this chapter, will lead to a corresponding adverse shift the risk and return structure of the investment projects in the economy.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Firm profit levels and investment There is traditionally a link between firm profit levels and investment. 1) High current profits might be an indicator of high future profits and therefore encourage investment. 2) High profits breed strong optimism which makes entrepreneurs more likely to undertake investment because they are more confident about the stream of future cash flows their business will generate. 3) Retained profits are a cheap source of investment funds so enable investments to be made when otherwise the cost of finance would be prohibitive. This is due to the fact that internal funds will not be subject to the fees and service charges, implicit profit margin, and repayment schedules that would be imposed if borrowing at commercial rates from financial institutions.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Theory of credit constraints The theory of credit constraints suggest two further reasons why investment might be strongly related to profit levels. 1) If firms are able to sufficiently fund investment through retained profits then the supply constraints from financial markets become less binding. 2) Reduce the moral hazard problem that helps to create the credit constraint in the first place. If a firm partially funds an investment project through retained earnings it has a greater stake in the project and more to lose if bankruptcy results. Therefore, moral hazard is mitigated and financial institutions would be more prepared to lend.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Global Applications 3.4 Firm Level Surveys of Investment Intentions The Confederation of British Industry (CBI) conducts a quarterly survey of manufacturing firms in the UK. There is a high positive correlation between investment and optimism. As optimism refers to expectations over the next four months, this provides evidence that investment decisions are forward-looking with expectations about the future being important. The survey reports that the availability of finance appears to be a much more important factor than the cost of finance in determining investment. This is particularly the case with the ability to raise external finance which suggests that the supply of investment funds and the issue of credit rationing is also an important factor in determining investment.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary Investment plays a dual role in the economy. As part of aggregate demand it can explain short run cycles in economic growth, and by adding to the stock of productive capital it might explain long run economic growth. Fixed business investment is the most significant part of investment expenditures. The two main theories accounting for this are the optimal capital stock and Tobin’s q models. The optimal capital stock model explains investment as the change in the capital stock towards its profit maximisation level. Investment will be positively related to the price of output and productivity, and negatively related to interest rates and the cost of capital goods.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary Tobin’s q implies that fixed business investment is driven by expectations about the future. If expected future discounted cash flows rise then investment will increase, but due to adjustment costs investment will be spread over time. Tobin’s q suggests that there is a direct link between stock markets and investment. Inventories are stocks of inputs or semi-finished goods held by firms. Inventory investment is a small part of total investment, but important because it is highly pro-cyclical. The accelerator model suggests that investment is driven by changes in output and that inventory investment is highly pro-cyclical.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary Residential investment, particularly in new houses is a not insignificant part of total investment. If property provides a flow of rents, then it can be treated as an asset with its value determined by the level of its expected future discounted rental payments. For this reason, it is easy to adapt the Tobin’s q model to explain this part of private investment. Finally, aggregate investment may be determined as much the availability of investment finance as the demand for investment. Due to problems of asymmetric information, financial markets have imperfect information about the quality of individual investment projects.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Summary Although an increase in interest rates implies that the returns from lending finance increase, it might also have a detrimental effect on the quality of loans. If the credit supply curve becomes backward bending then investment finance might be rationed. If these constraints are binding, then it opens up a new channel for investment to be driven by internal finance such as retained profits.

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Macroeconomics Chamberlin and Yueh Chapter 3 Lecture.

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Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1 © 2006 Cengage Learning Macroeconomics Chamberlin and Yueh Chapter 3 Lecture.

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