1. mankiw's macroeconomics modules
A PowerPointTutorial
to Accompany macroeconomics, 5th ed.
N. Gregory Mankiw
Mannig J. Simidian
CHAPTER SEVENTEEN
Investment

2. In this chapter, we’ll explain why investment is negatively related to the interest rate, what causes the investment function to shift and why investment rises during a boom and falls during a recession.

3. 3 Types of Investment Spending
Business fixed investment includes the equipment and structures that businesses buy to use in production.
Residential investment includes the new housing that people buy to live in and that landlords buy to rent out.
Inventory investment includes those goods that businesses put aside in storage, including materials and supplies, work in progress, and finished goods.

4. Business Fixed Investment
The standard model of business fixed investment is called the
neoclassical model of investment. It examines the benefits and costs of owning capital goods. Here are three variables that shift investment:
1) the marginal product of capital
2) the interest rate
3) tax rules
To develop the model, imagine that there are two kinds of firms: production firms that produce goods and services using the capital that they rent and rental firms that make all the investments in the economy.

5. The Rental Price of Capital
To see what variables influence the equilibrium rental price, let’s
consider the Cobb-Douglas production function as a good approximation
of how the actual economy turns capital and labor into goods and
services. The Cobb-Douglas production function is: Y = AKaL1-a ,
where Y is output, K capital, L labor, and a a parameter measuring the
level of technology, and a a parameter between 0 and 1 that measures
capital’s share of output. The real rental price of capital adjusts to
equilibrate the demand for capital and the fixed supply.
Capital supply
Real rental
price, R/P
Capital demand (MPK)
K Capital stock, K

6. The marginal product of capital for the Cobb-Douglas production function is MPK = aA(L/K)1-a. Because the real rental price equals the marginal product of capital in equilibrium,
we can write R/P = aA(L/K)1-a . This expression identifies the variables that determine the real rental price. It shows the following:
the lower the stock of capital, the higher the real rental price of capital
the greater the amount of labor employed, the higher the real rental price of capitals
the better the technology, the higher the real rental price of capital.
Events that reduce the capital stock, or raise employment, or improve
the technology, raise the equilibrium real rental price of capital.

7. The Cost of Capital
Let’s consider the benefit and cost of owning capital.
For each period of time that a firm rents out a unit of capital, the rental firm bears three costs:
1) Interest on their loans, which equals the purchase price of a unit of
capital PK times the interest rate, i, so i PK.
2) The cost of the loss or gain on the price of capital denoted as -DPK .
3) Depreciation d defined as the fraction of value lost per period
because of the wear and tear, so d PK .
Therefore the total cost of capital = i PK - DPK + dPK or
= PK (i - D PK/ PK + d)
Finally, we want to express the cost of capital relative to other goods in
the economy. The real cost of capital-- the cost of buying and renting
out a unit of capital measured in terms of the economy’s output is:
The Real Cost of Capital = (PK / P )(r + d), where r is the real interest
rate and PK / P equals the relative price of capital. To derive this equation, we assume that the rate of increase of the price of goods in general is equal to the rate of inflation.

8. The Determinants of Investment
Now consider a rental firm’s decision about whether to increase or
decrease its capital stock. For each unit of capital, the firm earns real
revenue R/P and bears the real cost (PK / P )(r + d).
The real profit per unit of capital is
Profit rate = Revenue - Cost
= R/P (PK / P )(r + d).
Because the real rental price equals the marginal product of capital, we
can write the profit rate as
Profit rate = MPK (PK / P )(r + d).
The change in the capital stock, called net investment depends on the
difference between the MPK and the cost of capital. If the MPK exceeds
the cost of capital, firms will add to their capital stock. If the MPK
falls short of the cost of capital, they let their capital stock shrink, thus:
DK = In [MPK - (PK / P )(r + d)],
where In ( ) is the function showing how much net investment responds
to the incentive to invest.

9. The Investment Function
We can now derive the investment function in the neoclassical model of
investment. Total spending on business fixed investment is the sum of
net investment and the replacement of depreciated capital.
The investment function is:
I = In [MPK - (PK / P )(r + d)] + dK.
investment
depends on
the cost of capital
marginal product of capital
amount of depreciation
This model shows why investment depends on the real interest rate A decrease in the real interest rate lowers the cost of capital.

10. Notice that business fixed investment increases when the interest rate falls-- hence the downward slope of the investment function. Also,
an outward shift in the investment function may be a result of an increase in the marginal product of capital.
Real interest
rate, r
Investment, I

11. Finally, we consider what happens as this adjustment of the capital
stock continues over time. If the marginal product begins above the
cost of capital, the capital stock will rise and the marginal product will
fall. If the marginal product of capital begins below the cost of capital,
the capital stock will fall and the marginal product will rise.
Eventually, as the capital stock adjusts, the MPK approaches the cost
of capital. When the capital stock reaches a steady state level,
we can write:
MPK = (PK / P )(r + d).
Thus, in the long run, the MPK equals the real cost of capital. The
speed of adjustment toward the steady state depends on how quickly
firms adjust their capital stock, which in turn depends on how costly
it is to build, deliver and install new capital.

12. The Stock Market and Tobin's q
The term stock refers to the shares in the ownership of corporations, and
the stock market is the market in which these shares are traded.
The Nobel-Prize-winning economist James Tobin proposed that firms
base their investment decisions on the following ratio, which is now
called Tobin’s q:
q = Market Value of Installed Capital
Replacement Cost of Installed Capital

13. The numerator of Tobin’s q is the value of the economy’s capital as determined by the stock market. The denominator is the price of capital as if it were purchased today. Tobin conveyed that net investment should depend on whether q is greater or less than 1. If q >1, then firms can raise the value of their stock by increasing capital, and if q < 1, the stock market values capital at less than its replacement cost and thus, firms will not replace their capital stock as it wears out. Tobin’s q measures the expected future profitability as well as the current profitability.

14. Summary of Business Fixed Investment
1) Higher interest rates increase the cost of capital and reduce business
fixed investment.
2) Improvements in technology and tax policies such as the corporate
income tax and investment tax credit shift the business fixed
investment function.
3) During booms higher employment increases the MPK and therefore,
increases business fixed investment.

15. Residential Investment
We will now consider the determinants of residential investment by looking at a simple model of the housing market. Residential investment includes the purchase of new housing both by people who plan to live in
it themselves and by landlords who plan to rent it to others.
There are two parts to the model:
1) the market for the existing stock of houses determines the equilibrium housing price
2) the housing price determines the flow of residential investment.

16. The Stock Equilibrium and the Flow Supply
The relative price of housing adjusts to equilibrate supply and demand
for the existing stock of housing capital. The relative price then
determines residential investment, the flow of new housing that
construction firms build.
The Market for Housing
The Supply of New Housing
PH/P
of housing PH/P
Relative Price
Demand
Stock of housing capital, KH
Flow of residential investment, IH

17. Changes in Housing Demand
When the demand for housing shifts, the equilibrium price of housing
changes, and this change in turn affects residential investment.
An increase in housing demand, perhaps due to a fall in the interest
rate, raises housing prices and residential investment.
The Market for Housing
The Supply of New Housing
PH/P
of housing PH/P
Relative Price
Demand'
Demand
Stock of housing capital, KH
Flow of residential investment, IH

18. Summary of Residential Investment
1) An increase in the interest rate increases the cost of borrowing
for home buyers and reduces residential housing investment.
2) An increase in population and tax policies shift the residential
housing investment function.
3) In a boom, higher income raises the demand for housing and
increases residential investment.

19. Inventory Investment
Inventory investment, the goods that businesses put aside in storage, is at the same time negligible and of great significance. It is one of the smallest components of spending-- but its volatility makes it critical in the study of economic fluctuations.

20. Reasons for Holding Inventories
When sales are high, the firm produces less that it sells and it takes the goods out of inventory. This is called production smoothing. Holding inventory may allow firms to operate more efficiently. Thus, we can view inventories as a factor of production. Also, firms don’t want to run out of goods when sales are unexpectedly high. This is called stock-out avoidance. Lastly, if a product is only partially completed, the components are still counted in inventory, and are called, work in
process.

21. The Accelerator Model of Inventories
The accelerator model assumes that firms hold a stock of
inventories that is proportional to the firm’s level of output. Thus, if
N is the economy’s stock of inventories and Y is output, then
N = b Y
where b is a parameter reflecting how much inventory firms wish to
hold as a proportion of output. Inventory investment I is the change in
the stock of inventories DN. Therefore, I = DN = b DY.

22. The Accelerator Model of Inventories
The accelerator model predicts that inventory investment is proportional to the change in output.
When output rises, firms want to hold a larger stock of inventory, so inventory investment is high.
When output falls, firms want to hold a smaller stock of inventory, so they allow their inventory to run down, and inventory investment is negative.
The model says that inventory investment depends on whether the economy is speeding up or slowing down.

23. Inventories and the Real Interest Rate
Like other components of investment, inventory investment depends
on the real interest rate. When a firm holds a good in inventory and
sells it tomorrow rather than selling it today, it gives up the interest it
could have earned between today and tomorrow. Thus, the real
interest rate measures the opportunity cost of holding inventories.
When the interest rate rises, holding inventories becomes more
costly, so rational firms try to reduce their stock. Therefore, an
increase in the real interest rate depresses inventory investment.

24. Summary of Inventory Investment
1) Higher interest rates increase the cost of holding inventories and
decrease inventory investment.
2) According to the accelerator model, the change in output shifts
the inventory investment function.
3) Higher output during a boom raises the stock of inventories firms
wish to hold, increasing inventory investment.

25. Key Concepts of Ch. 17 Business fixed investment Stock market
Residual investment
Inventory investment
Neoclassical model of investment
Depreciation
Real cost of capital
Net investment
Corporate income tax
Investment tax credit
Stock
Stock market
Tobin’s q
Financing constraints
Production smoothing
Inventories as a factor of
production
Stock-out avoidance
Work in process
Accelerator model