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The Theory of Investment
17
CHAPTER

CHAPTER 17 The Theory of Investment
This chapter begins by reviewing the three components of investment, and presents a time series graph of all three components, and total investment, to show the relative size of each component and to show their behavior over business cycles.

Then, the chapter presents the leading theory of each component of investment.

The chapter is of average length and difficulty.

IN THIS CHAPTER, YOU WILL LEARN:
leading theories to explain each type of investment
why investment is negatively related to the interest rate
things that shift the investment function
why investment rises during booms and falls during recessions

CHAPTER 17 The Theory of Investment

Three types of 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.

CHAPTER 17 The Theory of Investment

U.S. Investment and its components,
1970–2014
Total investment

Business fixed investment

Residential investment

Change in inventories

Billions of current dollars

CHAPTER 17 The Theory of Investment
Similar to Figure 17-1, p.508.

What we learn from this graph:
1. Business fixed investment is the largest of the three types of investment
2. Investment varies with the business cycle, rising in booms and falling in recessions.

Also interesting is the behavior of residential investment in the 2003-2009 period.

Source: U.S. Dept of Commerce, obtained from http://research.stlouisfed.org/fred2/
Series:

GPDI – total investment
PNFI – business fixed investment
PRFI – residential fixed investment
CBI – inventory investment

Recession 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 Total Investment 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 168.1 171.5 174 166.7 189.6 197.4 202.1 198.4 213 226.8 233.1 239.8 254.3 268.2 264.3 280.8 268.3 277.4 271 281.3 244.3 243.3 265.2 276.2 304.6 322.2 328.3 337.6 360.3 389.7 414.2 422.2 434.8 470.6 492.4 515.7 525.9 539.3 545.6 547.9 554.6 519.4 495 551.5 619.4 609.9 652.3 643.4 588.3 593.6 592.9 549.2 565.5 613.7 652.3 718.5 790.9 818.9 838.8 831.8 809.8 827 822.1 859.6 863.4 855.3 835.9 842.1 871.3 874.6 876.5 946.4 908.6 934.5 942 962.7 1005.3 1001 996.5 996 1010.9 1014.8 1000.7 947.6 924.6 926.6 947.4 978.8 956.8 1013.1 1024.2 1057.9 1083.9 1094.5 1095.9 1153 1202.1 1265 1251.5 1307.1 1327.3 1303.9 1303.2 1335.5 1355.2 1418.5 1474.5 1480 1522 1589.9 1625.3 1645.4 1712.3 1694.7 1739.8 1794.4 1850.7 1845.8 1890.9 1949.4 1945.9 2071.7 2055.8 2061.5 1967.6 1967 1937.3 1842.8 1910 1925.5 1927.9 1936.5 1960.2 1970.6 2048.2 2132.8 2155.2 2259.5 2311.3 2380.7 2475.1 2469.5 2527.2 2636.5 2699.7 2697 2684.4 2641.6 2634.2 2671.9 2658.2 2610.6 252 7 2493.2 2435.9 2243.2 1972.2 1825.9 1786.4 1928 1989.6 2092.7 2164.5 2156.4 2123.5 2212.6 2228.2 2395.1 2445.4 2489.3 2500.4 2481.4 2543.4 2594.6 2708.9 2745.1 2714.4 2843.7 2905.2 Business Fixed Investment 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998. 5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 123.8 125 126.3 123.5 126.3 129.5 131.2 134.7 140.6 144 147 155 162.8 171.3 176.6 180.1 183.4 188.8 194.5 197.6 193.1 193.3 197.8 202.9 209.5 215 222.6 230.2 243.3 253.7 263.3 275.9 282.4 309.3 325.1 341.4 356.7 364.3 383 391.3 404.5 394.7 405.7 422.8 443 462.9 482.1 503.8 500.1 490.1 478.7 471.5 462.1 466.4 485.4 514.7 531.5 558.3 576.6 590.9 599.4 609.1 604.4 618.1 613.5 605 602 610.6 596.6 608.4 625.5 630.5 641.5 659.4 666.3 681.9 696.3 708.9 731.2 727.5 740.9 734.2 744.3 737.6 729.8 726.8 720.1 717.6 714.2 736.7 748.6 768.3 776.6 792.4 798.4 829.5 841.1 855.7 871.9 906.6 944.3 956.6 965.5 982.5 1003.6 1026.6 1059.1 1083.5 1106.8 1129.2 1178.4 1181.9 1212.4 1246.1 1259.8 1292.9 1319.9 1351.4 1383.8 1391.4 1445.5 1494.7 1515.5 1519.4 1501.5 1467.6 1445 1401.5 1371.9 1351.6 1343.7 1328.4 1327.8 1359.1 1388.5 1411.5 1400.3 1440.2 1485.6 1526.5 1560.5 1595.2 1633 .8 1656.4 1729.4 1761 1793.6 1821.2 1864.7 1907.5 1937.9 1972.3 1981.6 1978.7 1947.3 1856.2 1712.3 1637.5 1600.3 1583.6 1594.4 1641.8 1677.4 1719.3 1722.4 1768.5 1854.5 1902.9 1942 1968.8 1978.3 1998.7 2010.3 2026.9 2060.2 2118.7 2134.6 2191.2 2244.3 Residential Investment 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 42.5 41.4 42.6 47.2 51 57 60.7 64 69.2 70.8 72.4 77.3 80.9 78.7 77.9 75.7 72.4 71.2 70.9 63.3 61.2 64 68.8 73 80.4 84.8 84.9 96.9 102.2 116.5 120 122.2 126.9 137 142.3 145.8 145.3 147.6 150.5 148 140.2 116.9 123.2 137.8 137.6 135.3 126.2 114.8 109.7 107.7 108.4 117.5 138.5 155 171.1 179.9 186.4 191.3 190.9 192.9 194.2 196.3 201.4 208.4 219.5 234.6 240.9 244.3 246.7 249.7 250 252.8 250.1 255.5 257.5 261.7 260.9 255.8 255.5 251.9 256 246.9 234.5 221.3 210.3 217.8 226.5 230.1 242.4 253.2 255.1 268.3 271.4 278 290.9 306.9 315.6 327.9 326.4 325.4 321.8 313.5 326.4 334.6 344.7 361.4 364.3 361.8 365.4 372.3 379 385.8 394.8 411.3 427.6 441.5 447.4 459.3 466.6 473.8 484.2 486.6 483.1 487.8 496.7 511 522.4 522.1 538.3 554.8 558.9 578.3 601.4 611.9 651.6 682.9 706 743.1 763.4 786.2 815.1 843.7 875.5 889.9 895.9 858.7 813.7 781.3 749.3 717.3 671.7 616.4 565.5 538.4 507.4 452.1 405.5 376.3 392 395.2 383.1 400.8 365.6 374.7 374.8 381.1 388.6 399.6 422.3 428.3 446.4 472.3 488.9 516.9 538 535.9 539.7 552.2 566.4 Change in Inventories 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 1.8 5.1 5.1 -4 12.3 10.9 10.2 -0.3 3.2 12 13.7 7.5 10.6 18.2 9.8 25 12.5 17.4 5.6 20.4 -10 -14 -1.4 0.3 14.7 22.4 20.8 10.5 14.8 19.5 30.9 24.1 25.5 24.3 25 28.5 23.9 27.4 12.1 8.6 9.9 7.8 -33.9 -9.1 38.8 11.7 44 24.8 -21.5 -4.2 5.8 -39.8 -35.1 -7.7 -4.2 23.9 73 69.3 71.3 48 16.2 21.6 16.3 33.1 30.4 15.7 -7 -12.8 28 16.5 1 63.1 17 19.6 18.2 19.1 48.1 36.3 9.8 16.6 14 33.7 21.9 -11.3 -15.5 -18 0.8 31.1 0.2 23.2 20.5 21.3 35.9 24.1 6.6 16.6 45.4 81.4 53.2 75.1 61.2 33.8 11.3 18.4 6.9 30.5 51.1 34.7 49.8 88.4 67.9 77.7 105.1 37.3 52.4 60 83.4 35.1 40.5 84.2 16.2 90.4 57.2 54.3 -30.6 -11.6 -30.1 -80.8 -0.2 19.1 25.3 29.8 31 -0.4 8.1 38.4 48.9 76.2 62.3 68 99.5 30.6 17.9 90.2 74.4 77.3 77.1 39.1 20.2 47.1 48.6 21.9 -20.1 -23.9 -18.8 -65.1 -145.6 -187.9 -205.9 -50.8 12.1 50.1 121.5 62.4 26.3 63 -14.9 92.6 81.1 92.2 75.7 10.4 44.2 50.8 110.7 90.5 40.1 100.3 94.5

Understanding business fixed investment
The standard model of business fixed investment:
the neoclassical model of investment
Shows how investment depends on:
MPK
interest rate
tax rules affecting firms

CHAPTER 17 The Theory of Investment

Two types of firms
For 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 to
production firms.
In this context,
“investment” is the rental firms’
spending on new capital goods.

CHAPTER 17 The Theory of Investment

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.

The 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.

K
capital stock
real rental price, R/P

capital supply

capital demand (MPK)

equilibrium rental rate

CHAPTER 17 The Theory of Investment

The 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).

Factors that affect the rental price
For the Cobb-Douglas production function,
the MPK (and hence equilibrium R/P ) is
The equilibrium R/P would increase if:
iK (e.g., earthquake or war)
hL (e.g., pop. growth or immigration)
hA (technological improvement or deregulation)

CHAPTER 17 The Theory of Investment

(It might be worth reminding students that A represents the level of technology, and α 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 (Chapter 3 and the economic growth chapters).

If students are wondering where the MPK equation comes from, either refer them to Chapter 3, or, if they are acquainted with basic calculus, take the derivative of the C-D 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 comply 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.

Rental 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 to
production firms.

CHAPTER 17 The Theory of Investment

The cost of capital
Components of the cost of capital:
interest cost: i × PK,
where PK = nominal price of capital
depreciation cost: δ × PK,
where δ = rate of depreciation
capital loss: −ΔPK
(a capital gain, ΔPK > 0, reduces cost of K )
Add these three parts to get the total cost of capital:

CHAPTER 17 The Theory of Investment

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 of 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.

Then, interest cost = depreciation cost = capital loss =
total cost =
The cost of capital
Example: car rental company (capital: cars)
Suppose PK = $10,000, i = 0.10, δ = 0.20,
and ΔPK/PK = 0.06
Nominal cost
of capital

$1000
2000
−600
$2400

CHAPTER 17 The Theory of Investment

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.)

The cost of capital
For simplicity, assume ΔPK/PK = π.
Then, the nominal cost of capital equals
PK(i + δ − π) = PK(r + δ)
and the real cost of capital equals

The real cost of capital depends positively on:
the relative price of capital
the real interest rate
the depreciation rate

CHAPTER 17 The Theory of Investment

The 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.

The rental firm’s profit rate
A firm’s net investment depends on its profit rate:

If profit rate > 0,
then increasing K is profitable
If profit rate < 0, then the firm increases profits by reducing its capital stock (i.e., not replacing capital as it depreciates) CHAPTER 17 The Theory of Investment In plain English, the profit rate equals (the rental price of capital) minus (the user cost of capital) Net investment & gross investment Hence, where In[ ] is a function that shows how net investment responds to the incentive to invest. Total spending on business fixed investment equals net investment plus replacement of depreciated K: CHAPTER 17 The Theory of Investment The equation in the yellow box simply states “net investment depends on the profit rate.” It might be useful to remind students that gross investment is simply net investment plus depreciation. The investment function An increase in r : raises the cost of capital reduces the profit rate and reduces investment I r I2 I1 r1 r2 CHAPTER 17 The Theory of Investment Finally, we see where our familiar investment function comes from. The investment function An increase in MPK or decrease in PK/P increases the profit rate increases investment at any given interest rate shifts I curve to the right I r I1 r1 I2 CHAPTER 17 The Theory of Investment Here’s a challenge for particularly bright students: Ask what happens to the investment curve given an increase in the depreciation rate. Tell them to justify their answer based on the investment equation we have derived. Answer: The impact on the curve is ambiguous. The depreciation rate appears in two different places in the equation. First, it appears in the expression for the profit rate, which is the argument of the net investment function. An increase in the depreciation rate would raise the cost of capital and hence reduce the profit rate and the incentive to invest (*net* investment). This would tend to shift the curve left. Second, the depreciation rate appears as a coefficient on K. An increase in the depreciation rate means that more investment (*gross* investment) is needed to replace depreciating capital and keep the total capital stock at its optimal level. This effect would shift the curve right. The net impact of the two opposing forces is ambiguous, without knowing the specific form of the In( ) function. Note: This exercise is simply for practice, and does not correspond to a real-world policy example. Taxes and investment Two of the most important tax policies affecting investment: Corporate income tax Investment tax credit CHAPTER 17 The Theory of Investment Corporate income tax: A tax on profits Impact on investment depends on definition of “profit.” In our definition (rental price minus cost of capital), depreciation cost is measured using current price of capital, and the CIT would not affect investment. But, the 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. CHAPTER 17 The Theory of 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 $8000. 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.) The Investment Tax Credit (ITC) The ITC reduces a firm’s taxes by a certain amount for each dollar it spends on capital. Hence, the ITC effectively reduces PK , which increases the profit rate and the incentive to invest. CHAPTER 17 The Theory of Investment Tobin’s q numerator: the stock market value of the economy’s capital stock. denominator: the actual cost to replace the capital goods that were purchased when the stock was issued. If q > 1, firms buy more capital to raise the market value of their firms.
If q < 1, firms do not replace capital as it wears out. CHAPTER 17 The Theory of Investment Relation between q theory and neoclassical theory 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 losses, so their stock market values fall, so q is low. CHAPTER 17 The Theory of Investment The stock market and GDP Reasons for a relationship between the stock market and GDP: 1. A wave of pessimism about future profitability of capital would: cause stock prices to fall cause Tobin’s q to fall shift the investment function down cause a negative aggregate demand shock CHAPTER 17 The Theory of Investment The stock market and GDP Reasons for a relationship between the stock market and GDP: 2. A fall in stock prices would: reduce household wealth shift the consumption function down cause a negative aggregate demand shock CHAPTER 17 The Theory of Investment The stock market and GDP Reasons for 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. CHAPTER 17 The Theory of Investment The stock market and GDP Percent change from 1 year earlier Percent change from 1 year earlier Stock prices (left scale) Real GDP (right scale) CHAPTER 17 The Theory of Investment Similar to Figure 17-4 on p.518. The figure shows that the stock market and GDP tend to move together, but the association is far from precise. Source: FRED. Stock market: series DJIA, quarterly (end of period), percent change from year ago Real GDP: series GDPC1, quarterly, percent change from year ago % Change in DJIA from 4 quarters earlier 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012. 25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 -15.193642384106 -16.024928379014 -21.7203586848223 -6.44578090986239 4.81783197561096 15.1227770917932 30.3732096616096 16.6311721091655 6.11262098889049 4.01716111768414 4.25185717171264 7.44823543998467 14.9045158391373 1.09599234612522 -4.17962821437413 -0.647245796049384 -16.8172219615204 -10.9704419511887 -9.8618288025163 -35.817759476296 -27.2347977340573 -9.27505078660178 9.54374945476752 30.6002928257687 37.6786781451392 30.1113063854716 14.0832091377604 24.7279185771149 17.8599500240495 -7.99439691830508 -8.62402520991643 -14.449752067785 -17.3373811775245 -17.7130117992496 -10.6242496998799 2.20868600299843 -3.06573386154828 13.6466359179035 2.6448501129495 1.37557459980134 4.19001006198681 -8.62628353470631 3.24883120590999 6.23084547639934 14.9331139566493 27.7594654788419 12.5541524564476 -8.84150919113704 -9.23142356248508 -18.040184486039 -16.885390221931 5.44365749782348 19.6045714285714 37.3445798947458 50.5006589237989 37.5877266387726 20.2667838783037 3.08487385290657 -7.3292088120724 -2.14251538767203 -3.73975084217887 8.74674862004136 17.9318262098198 10.1035045702779 27.6583276244872 43.5616286963798 41.7279439294326 33.0377908070719 22.6738735476863 26.7281055311474 27.7806542964622 46.8833093834508 2.8144369018004 -13.7385071311109 -11.4457955865753 -18.6177916095337 11.1561647768049 15.3697574519884 13.9304574382153 27.446034142486 26.9697794215985 18.0321936502123 18.0581625042007 -8.92521594462311 -4.34185674851082 7.63331991238212 1.07543678771405 23.0089542014614 20.3203906350858 11.0372495590042 13.9730807406059 8.44910284841071 4.17441137580748 6.17035546613013 5.95325627086773 8.66410323811154 13.7220510676712 5.76313422277597 3.09663033833133 8.10296136276694 2.1403322775959 14.4398141521794 25.6869041313559 24.6121060889521 33.4515600713532 34.3808701466439 24.1111915892979 22.8246343765399 26.013656119067 17.8327373217782 35.6903988413035 35.0736207896065 22.6414216526293 33.9489145558276 17.4482815247126 -2.46486584454128 16.4965700376189 11.4167942393831 21.7591626754968 33.3738524947673 24.8464100103768 10.5646754446942 -4.75739127264773 3.12896078640053 -6.18158738990949 -9.07772039803742 0.522468039500884 -17.0101603324859 -7.12822841468273 5.31468559788441 -12.0490242741552 -14.1638508835097 -16.7568376622729 -23.1613808750156 -2.76635008252834 22.1521287916302 25.2963782517699 29.5848904580731 16.1441995801266 8.70010544406181 3.1676026289858 1.42022688872798 -1.53728196281387 4.83535012894267 -0.607392570336987 8.51827 10.50621 16.28785 11.20708 20.25431 18.97891 6.43232 -0.74031 -15.35288 -21.91315 -33.8371 -37.95166 -25.57716 -10.49134 18.81936 42.68293 15.70996 11.07639 11.02277 13.47656 27.01365 1.16175 5.52838999999999 7.24293 3.75171 23.12528 7.2566 10.34284 15.75696 12.59599 26.49941 12.88963 12.85749 12.64555 % Change in Real GDP from 4 quarters earlier 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2012.25 2012.5 2012.75 2013 2013.25 2013.5 2013.75 2014 2014.25 2014.5 0.294704253862402 0.184025407378818 0.442425672487018 -0.154096903244924 2.76029918081444 3.15527508665896 3.05984612673986 4.45493129136617 3.46889261163422 5.32483198345683 5.49350353316618 6.93299994317213 7.74083689249922 6.46542321116929 4.89142178046673 4.17441675081043 0.686599647631881 -0.210024844402328 -0.669499163126041 -1.99209284530034 -2.32881294871463 -1.83516850183516 0.819183408943604 2.537476 57713929 6.15976393719041 6.14704805731318 4.89830552055745 4.29706337724307 3.1642428153075 4.42889868709511 5.77997842925778 4.9961062980629 4.14491568235944 6.1327986790895 5.28803818881215 6.70297832889094 6.51852536265359 2.58473163684855 2.3175455585879 1.25985620261963 1.41605586156049 -0.756098617791074 -1.64555056034761 -0.102966728875721 1.64646011076185 2.94483616756533 4.38937975680169 1.21754815435161 -2.46965521593706 -1.15356885364096 -2.7173116004274 -1.410811269518 1.47962815175895 3.2007551379414 5.64457078864625 7.74246304146674 8.4826457523008 7.93040369184717 6.87187850372032 5.56032674908625 4.52782131661442 3.62473758209587 4.23072521268073 4.17194861218852 4.19111169425129 3.73213389587942 3.12019617890344 2.83882451233245 2.42502743447209 3.09795560015051 3.00094056682462 4.25990356934706 4.22060244138052 4.44907890163366 4.08339076498966 3.69962563312045 4.13562978192727 3.58402662229617 3.8702201622248 2.72473332571018 2.83208182288969 2.47373662736531 1.66539172563269 0.554981315098996 -0.966290012904857 -0.691287581904247 -0.271189628956158 1.00420659771641 2.60933129926264 3.00380408189036 3.63093366865767 4.3119510247538 3.36998606163853 2.93766090474439 2.42074927953889 2.69426474340693 3.50283163035988 4.25170827564646 4.37461126084768 4.15826244555526 3.40744600775867 2.23050450527638 2.4304767309875 2.01086117620644 2.4580755340295 4.00748697461971 4.03640242128739 4.44453615054475 4.53179222340628 4.27880741337632 4.6773270134608 4.34101176129703 4.52353256394504 3.92164438605981 3.98880691935893 4.98340128498038 4.92672435352375 4.80474898067938 4.7543911150252 4.82139207175577 4.16746114977595 5.3755557657743 4.14044346881822 2.90889069866141 2.30296651374571 1.00433153039926 0.640213479240727 0.397917897388454 1.59021269933573 1.46429801464298 2.26158645276292 1.93951639762862 1.49707190348289 1.81654932276326 2.969822420743 3.86621796756733 4.11587349789597 3.90488890800766 2.98362182064412 2.89605855029306 3.27711746997365 3.07295817506235 3.12422947316512 2.81149052816076 3.04705229714055 2.94157 2.17467 2.38983 1. 23676 1.70738 2.30028 1.86792 1.11028 0.84037 -0.31395 -2.76685 -3.45546 -4.06191 -3.2844 -0.24079 1.59861 2.7188 3.07585 2.73073 1.89321 1.65266 1.18285 1.68217 2.6456 2.31560999999999 2.73083 1.60234 1.72439 1.75983 2.25904 3.12628 1.88758 2.58737 2.69774 Alternative views of the stock market: The efficient markets hypothesis Efficient markets hypothesis (EMH): The market price of a company’s stock is the fully rational valuation of the company, given current information about the company’s business prospects. Stock market is informationally efficient: each stock price reflects all available information about the stock. Implies that stock prices should follow a random walk (be unpredictable) and should only change as new information arrives. CHAPTER 17 The Theory of Investment Alternative views of the stock market: Keynes’s “beauty contest” Idea based on newspaper beauty contest in which a reader wins a prize if he or she picks the women most frequently selected by other readers as most beautiful. Keynes proposed that stock prices reflect people’s views about what other people think will happen to stock prices; the best investors could outguess mass psychology. Keynes believed stock prices reflect irrational waves of pessimism/optimism (“animal spirits”). CHAPTER 17 The Theory of Investment Alternative views of the stock market: EMH vs. Keynes’s beauty contest Both views persist. There is evidence for the EMH and random-walk theory (see p.508). Yet, some stock market movements do not seem to rationally reflect new information. CHAPTER 17 The Theory of Investment Financing constraints Neoclassical theory assumes firms can borrow to buy capital whenever doing so is profitable. But 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, investment might be worthwhile. But if firm faces financing constraints and current profits are low, firm might be unable to obtain funds. CHAPTER 17 The Theory of Investment Residential investment The flow of new residential investment, IH , depends on the relative price of housing PH /P. PH /P determined by supply and demand in the market for existing houses. CHAPTER 17 The Theory of Investment How residential investment is determined KH Demand (a) The market for housing Supply and demand for houses determines the eq’m price of houses. Supply The equilibrium price of houses then determines residential investment: Stock of housing capital CHAPTER 17 The Theory of Investment How residential investment is determined KH Demand IH Supply (a) The market for housing (b) The supply of new housing Supply Stock of housing capital Flow of residential investment CHAPTER 17 The Theory of Investment How residential investment responds to a fall in interest rates KH Demand IH Supply Supply Stock of housing capital Flow of residential investment (a) The market for housing (b) The supply of new housing CHAPTER 17 The Theory of Investment Figure 17-6 (p.524). The main point of this slide is to establish more formally the dependence of investment (in this case, residential investment) on the interest rate. A fall in interest rates increases the demand for houses, bidding up the price of houses (relative to the general level of prices). The higher relative price of houses motivates firms to increase residential investment. U.S. Housing Prices and Housing Starts, 2000-2014 Housing Price Index = 100 in 2000 1st quarter Housing Starts (thousands) Housing prices (left scale) Housing starts (right scale) CHAPTER 17 The Theory of Investment This slide replicates Figure 17-7 on p.525 with two differences: (1) Both series are plotted on the same graph (using different vertical scales) to show the clear relation between them, and (2) the house price data are not inflation-adjusted here. From 2000-2006, we can easily deduce that the demand curve for houses is shifting to the right (as depicted in Figure 17-6, reproduced on the previous slide), because both the price of houses and the quantity of housing starts rises. As the textbook discusses (p.524), interest rates were low and credit was widely available in the early 2000s, leading to the increase in demand Technical note: The two series are measured in different units against different scales, so it would not be appropriate to compare the magnitudes of their pre-2006 rise and post-2006 fall based on this graph. However, it is clear that both series rise dramatically before 2006 and fall even faster starting about 2006. Sources: House prices are the seasonally-adjusted S&P/Case-Shiller S&P Case-Shiller 20-City Home Price Index (series SPCS20RSA in FRED). Housing starts are from the U.S. Department of Commerce, “New privately owned housing units started,” monthly, seasonally adjusted from: http://www.census.gov/construction/nrc/historical_data/ (a) Real Housing Price 2000.08333333333 2000.16666666667 2000.25 2000.33333333333 2000.41666666667 2000.5 2000.58333333333 2000.66666666667 2000.75 2000.83333333333 2000.916666 66667 2001 2001.08333333334 2001.16666666667 2001.25 2001.33333333334 2001.41666666667 2001.5 2001.58333333334 2001.66666666667 2001.75 2001.83333333334 2001.91666666667 2002 2002.08333333334 2002.16666666667 2002.25 2002.33333333334 2002.41666666667 2002.5 2002.58333333334 2002.66666666667 2002.75 2002.83333333334 2002.91666666667 2003.00000000001 2003.08333333334 2003.16666666667 2003.25000000001 2003.33333333334 2003.41666666667 2003.50000000001 2003.58333333334 2003.66666666667 2003.75000000001 2003.83333333334 2003.91666666667 2004.00000000001 2004.08333333334 2004.16666666667 2004.25000000001 2004.33333333334 2004.41666666667 2004.50000000001 2004.58333333334 2004.66666666667 2004.75000000001 2004.83333333334 2004.91666666668 2005.00000000001 2005.08333333334 2005.16666666668 2005.25000000001 2005.33333333334 2005.41666666668 2005.50000000001 2005.58333333334 2005.66666666668 2005.75000000001 2005.83333333334 2005.91666666668 2006.00000000001 2006.08333333334 2006.16666666668 2006.25000000001 2006.33333333334 2006.41666666668 2006.50000000001 2006.58333333335 2006.66666666668 2006.75000000001 2006.83333333335 2006.91666666668 2007.00000000001 2007.08333333335 2007.1666666 6668 2007.25000000001 2007.33333333335 2007.41666666668 2007.50000000001 2007.58333333335 2007.66666666668 2007.75000000001 2007.83333333335 2007.91666666668 2008.00000000001 2008.08333333335 2008.16666666668 2008.25000000001 2008.33333333335 2008.41666666668 2008.50000000002 2008.58333333335 2008.66666666668 2008.75000000002 2008.83333333335 2008.91666666668 2009.00000000002 2009.08333333335 2009.16666666668 2009.25000000002 2009.33333333335 2009.41666666668 2009.50000000002 2009.58333333335 2009.66666666668 2009.75000000002 2009.83333333335 2009.91666666668 2010.00000000002 2010.08333333335 2010.16666666668 2010.25000000002 2010.33333333335 2010.41666666669 2010.50000000002 2010.58333333335 2010.66666666669 2010.75000000002 2010.83333333335 2010.91666666669 2011.00000000002 2011.08333333335 2011.16666666669 2011.25000000002 2011.33333333335 2011.41666666669 2011.50000000002 2011.58333333335 2011.66666666669 2011.75000000002 2011.83333333328 2011.91666666661 2011.99999999994 2012.08333333327 2012.1666666666 2012.24999999993 2012.33333333326 2012.41666666659 2012.49999999992 2012.58333333325 2012.66666666658 2012.74999999991 2012.83333333324 2012.91666666656 2012.99999999989 2013.08333333322 2013.16666666655 2013.24999999988 2013.33333333321 2013.41666666654 2013.49999999987 2013.5833333332 2013.66666666653 2013.74999999986 2013.83333333319 2013.91666666652 2013.99999999985 2014.08333333318 2014.16666666651 2014.24999999984 2014.33333333317 2014.4166666665 2014.49999999983 2014.58333333316 2014.66666666649 2014.74999999982 2014.83333333315 100.59 101.69 102.78 104 105.25 106.4 107.13 107.86 108.61 109.49 110.57 111.8 113.05 114.13 115.09 115.84 116.3 116.9 117.5 118.24 119.03 119.69 120.27 120.67 121.36 122.19 123.33 124.5 125.93 127.39 128.88 130.3 131.53 132.85 134.1 135.41 136.47 137.46 138.39 139.24 140.15 140.92 142.12 143.53 145.26 146.99 148.82 150.76 152.63 154.54 156.96 159.34 161.75 164.31 166.39 168.03 169.66 171.29 173.08 175.08 177.55 180.26 183.28 185.49 187.55 189.53 191.38 193.31 195.62 197.87 200.13 202.16 203.77 205.37 206.34 206.61 206.49 205.81 204.93 204.03 203.57 203.52 203.63 203.45 203.73 204.08 204.27 202.82 200.99 198.84 196.84 194.8 193.1 190.94 187.87 185.06 182.11 178.53 175.57 172.38 169.51 167.17 164.39 162.02 159.08 156.25 153.61 150.68 147.67 145.58 143.23 141.54 140.79 141.28 142.22 143.36 144 144.71 145.4 146.17 146.87 146.9 146.93 147.11 147.23 147.04 146.33 145.35 144.4 143.47 143.16 142.88 142.52 142.11 141.26 140.89 140.46 140.36 140.18 139.75 139.12 138.39 137.75 137.26 137.08 137.23 137.65 138.3 139.62 141.02 141.69 142.45 143.26 144.34 145.49 146.96 148.3 150.1 152.39 154.72 156.39 157.83 159.07 160.68 162.25 163.99 165.51 166.72 167.91 169.47 171.22 171.39 170.92 170.52 169.82 169.68 170.09 171.39 (b) Housing Starts 2000.08333333333 2000.16666666667 2000.25 2000.33333333333 2000.41666666667 2000.5 2000.58333333333 2000.66666666667 2000.75 2000.83333333333 2000.91666666667 2001 2001.08333333334 2001.16666666667 2001.25 2001.33333333334 2001.41666666667 2001.5 2001.58333333334 2001.66666666667 2001.75 2001.83333333334 2001.91666666667 2002 2002.08333333334 2002.16666666667 2002.25 2002.33333333334 2002.41666666667 2002.5 2002.58333333334 2002.66666666667 2002.75 2002.83333333334 2002.91666666667 2003.00000000001 2003.08333333334 2003.16666666667 2003.25000000001 2003.33333333334 2003.41666666667 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2013.16666666655 2013.24999999988 2013.33333333321 2013.41666666654 2013.49999999987 2013.5833333332 2013.66666666653 2013.74999999986 2013.83333333319 2013.91666666652 2013.99999999985 2014.08333333318 2014.16666666651 2014.24999999984 2014.33333333317 2014.4166666665 2014.49999999983 2014.58333333316 2014.66666666649 2014.74999999982 2014.83333333315 1636 1737 1604 1626 1575 1559 1463 1541 1507 1549 1551 1532 1600 1625 1590 1649 1605 1636 1670 1567 1562 1540 1602 1568 1698 1829 1642 1592 1764 1717 1655 1633 1804 1648 1753 1788 1853 1629 1726 1643 1751 1867 1897 1833 1939 1967 2083 2057 1911 1846 1998 2003 1981 1828 2002 2024 1905 2072 1782 2042 2144 2207 1864 2061 2025 2068 2054 2095 2151 2065 2147 1994 2273 2119 1969 1821 1942 1802 1737 1650 1720 1491 1570 1649 1409 1480 1495 1490 1415 1448 1354 1330 1183 1264 1197 1037 1084 1103 1005 1013 973 1046 923 844 820 777 652 560 490 582 505 478 540 585 594 586 585 534 588 581 614 604 636 687 583 536 546 599 594 543 545 539 630 517 600 554 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Yet, in the typical recession, more than half of the fall in spending is due to a fall in inventory investment. CHAPTER 17 The Theory of Investment Motives for holding inventories 1. production smoothing Sales fluctuate, but many firms find it cheaper to produce at a steady rate. When sales < production, inventories rise. When sales > production, inventories fall.

CHAPTER 17 The Theory of Investment

Motives for holding inventories
1. production smoothing
2. inventories as a factor of production
Inventories allow some firms to operate more efficiently.
samples for retail sales purposes
spare parts for when machines break down

CHAPTER 17 The Theory of Investment

Motives for holding inventories
1. production smoothing
2. inventories as a factor of production
3. stock-out avoidance
To prevent lost sales when demand is higher than expected.

CHAPTER 17 The Theory of Investment

Motives for holding inventories
1. production smoothing
2. inventories as a factor of production
3. stock-out avoidance
4. work in process
Goods not yet completed are counted in inventory.

CHAPTER 17 The Theory of Investment

Inventories, the real interest rate, and credit conditions
Inventories and the real interest rate
The real interest rate is the opportunity cost of holding inventory (instead of bonds, e.g.)
Example: High interest rates in the 1980s motivated many firms to adopt just-in-time production, which is designed to reduce inventories.
Inventories and credit conditions
Many firms purchase inventories using credit.
Example: The credit crunch of 2008–09 helped cause a huge drop in inventory investment.

CHAPTER 17 The Theory of Investment

As explained on p.527, inventory investment fell from $72 billion in 2006 to –$34 billion in 2008 and –$148 billion in 2009. Much of this drop can be attributed to the credit crunch that accompanied the recession of 2008-2009.

CHAPTER SUMMARY
All 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.

CHAPTER 17 The Theory of Investment

CHAPTER SUMMARY
Investment 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.

CHAPTER 17 The Theory of Investment

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K
P
r
P
d
+

(
)
(
)
Profit rate ==
KK
PP
R
rMPKr
PPP
dd
-+-+

(
)
(
)
net investment =
nK
KIMPKPPr
d
éù
D=-+
ëû

(
)
(
)
gross investment
nK
KK
IMPKPPrK
d
dd
=D+
éù
=-++
ëû

(
)
(
)
nK
IIMPKPPrK
dd
éù
=-++
ëû

Market value of installed capital
Replacement cost of installed capital
q
=

H
P
P

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