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CHAPTER TWO
INVESTMENT SPENDING
Investment is the most volatile component of GDP. When expenditure on goods and
services falls during a recession, much of the decline is usually due to a drop in
investment spending.
There are three types of investment spending.
1. Business fixed investment includes the equipment and structures that
businesses buy to use in production.
2. Residential investment includes the new housing that people buy to live in and
that landlords buy to rent out,
3. Inventory investment includes those goods that businesses put aside in
storage, including materials and supplies, work in process, and finished goods.
We build models of each type of investment to explain these fluctuations. As we
develop the models, it is useful to keep in mind the following three questions:
 Why investment is negatively related to the interest rate?
 What causes the investment function to shift?
 Why does investment rise during booms and fall during recessions?
2.1 BUSINESS FIXED INVESTMENT
The standard model of business fixed investment is called the neoclassical model of
investment. The neoclassical model examines the benefits and costs to firms of owning
capital goods. The model shows how the level of investment – the addition to the stock of
capital-is related to the MPK, the interest rate, and the tax rules affecting firms.
To develop the model, there are two kinds of firms in the economy.
 Production firms produce goods and services using capital that they rent.
 Rental firms make all the investments in the economy; they buy capital and rent it
out to the production firms.
Of course, most firms in the actual economy perform both functions: they produce goods
and services, and they invest in capital for future production. Our analysis is simpler,
however, if we separate these two activities by imagining that they take place in different
firms.

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THE RENTAL PRICE OF CAPITAL /PRODUCTION FIRM/

The firm decides how much capital to rent by comparing the cost and benefit of each unit
of capital. The firm rents capital at a rental rate R and sells output at a price P; the real
cost of a unit of capital to the production firm is R/P. The real benefit of a unit of
capital is the MPK -the extra output produced with one more unit of capital. The MP K
declines as the amount of capital rises: the more capital the firm has, the less an
additional unit of capital will add to its production.
To maximize profit, the firm rents capital until the MP K falls to equal the real rental price.
For the reason discussed, the MPK determines the demand curve. At any point in time, the
amount of capital in the economy is fixed, so the supply curve is vertical. The real rental
price of capital adjusts to equilibrate supply and demand.
To see what variables influence the equilibrium rental price, it is instructive to consider
a particular production function. Many economists consider the Cobb-Douglas
production function 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, A a parameter measuring the level of technology,
and a a parameter between zero and one that measures capital's share of output. The MP K
for the Cobb-Douglas production function is MPK = aA(L/K)1-a
Because the real rental price equals the MPK 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 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 capital
 The better the technology, the higher the real rental price of capital
Events that reduce the capital stock (an earthquake), or rise employment (an expansion in
AD), or improve the technology (a scientific discovery) rise the equilibrium real rental
price of capital.

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THE COST OF CAPITAL /RENTAL FIRM/

These firms like car-rental companies, merely buy capital goods and rent them out. Since
our goal is to explain the investment made by the rental firms, we begin by considering
the benefit and cost of owning capital.
The benefit of owning capital is the revenue from renting it to the production firms. The
rental firm receives the real rental price of capital, R/P, for each unit of capital it owns
and rents out.
The rental firm bears three costs:
1. If the firm borrows to buy the capital, it must pay interest. If P K is the purchase price
of a unit of capital, and i is the nominal interest rate, then iPK is the interest cost.
2. If the price of capital falls, the firm loses, because the firm's asset has fallen in value.
If the price rises, the firm gains. The cost of this loss or gain is - Δ PK.
3. If δ is the rate of depreciation-the fraction of value lost per period due to wear and
tear-then the dollar cost of depreciation is δ PK.
The total cost of renting out a unit of capital for one period is therefore
Cost of Capital = iPK - Δ PK + δ PK
= PK(i - Δ PK /PK + δ )
The cost of capital depends on the price of capital, the interest rate, the rate at which
capital prices are changing, and the depreciation rate.

For example, consider the cost of capital to a car-rental company. The company buys cars
at $10,000 each and rents them out to other business. The company faces an interest rate i
of 10% per year, so the interest cost iPKis $1,000 per year for each car the company owns.
Car prices are rising at 6% per year, so, excluding wear and tear, the firm gets a capital
gain Δ PK of $600 per year. Car depreciates at 20% per year, so the loss due to wear and
tear δ PK is $2,000 per year. Therefore, the company's cost of capital is
Cost of Capital = $1,000 - $600 + $2,000 =$2,400
The cost to the car-rental company of keeping a car in its capital stock is $2400 per year.

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To make the expression for the cost of capital simpler and easier to interpret, we assume
that the price of capital goods rises with the prices of other goods. In this case, Δ PK /PK
equal the overall rate of inflation π . Because i - π equals the real interest rate r, we can
write the cost of capital as
Cost of Capital = PK(r + δ )
This equation states that the cost of capital depends on the price of capital, the real
interest rate, and the depreciation rate.
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 units
of the economy's output-is
Real Cost of Capital = (PK/P)(r + δ )
This equation states that the real cost of capital depends on the relative price of a capital
good PK/P, the real interest rate r, and the depreciation rateδ .
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 + δ ). The real profit per unit of capital is
Profit Rate = Revenue - Cost
= R/P - (PK/P)(r + δ )
Since the real rental price in equilibrium equals the MPK, we can write the profit rate as
Profit Rate = MPK - (PK/P) (r + δ )
The rental firm makes a profit if the MPK is greater than the cost of capital. It incurs a
loss if the MPK is less than the cost of capital.
We can now see the economic incentives that lie behind the rental firm's investment
decision. The firm's decision regarding its capital stock - that is, whether to add to it or to
let it depreciate - depends on whether owning and renting out capital is profitable. The
change in the capital stock, called net investment, depends on the difference between the
MPK and cost of capital. If the MPK exceeds the cost of capital, firms find it profitable to
add to their capital stock. If the MP K falls short of the cost of capital, they let their capital
stock shrink.

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We can also now see that the separation of economic activity between production and
rental firms-although useful to clarify our thinking - is not necessary for our conclusion
regarding how firms choose investment.
For a firm that both uses and owns capital, the benefit of an extra unit of capital is the
MPK, and the cost is the cost of capital. Like a firm that owns and rents out capital, this
firm adds to its capital stock if the MP exceeds the cost of capital. Thus, we can write
Δ K = In (MPK-(PK/P)(r + δ ))

Where In is the function showing how much net investment responds to the incentive to
invest.
We can now derive the investment function. Total spending on business fixed I is the sum
of net I and the replacement of depreciated capital. The I function is
I = In (MPK-(PK/P)(r + δ )) + δ K.
Business fixed I depends on the MPK, the cost of capital, and the amount of depreciation.
This model shows why investment depends on the interest rate. An increase in the real
interest rate raises the cost of capital.
The model also shows what causes the investment schedule to shift. Any event that raises
the MPK increases the profitability of investment and causes the I schedule to shift
outward. For example, a technological innovation that increases the production function
parameter A raises the MPK and, for any given interest rate, raises the amount of capital
goods that rental firms wish to buy.
Finally, consider what happens as this adjustment of the capital stock continues over
time. If the MP begins above the cost of capital, the capital stock will rise and the MP
will fall. If the MPK begins below the cost of capital, the capital stock will fall and the
MP will rise. Eventually, as the capital stock adjusts, the MP K approaches the cost of
capital. When the capital stock reaches a steady-state level, we can write
MPK = (PK/P)(r + δ )
Thus, in the long run, the MPK equals the real cost of capital.
Taxes and Investment
The tax laws influence firms' incentives to accumulate capital in many ways. Sometimes
policymakers change the tax laws in order to shift the investment function and influence

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aggregate demand. Here we consider two of the most important provisions of corporate
taxation: the corporate income tax and the investment tax credit.
The effect of a corporate income tax on investment depends on how the law defines
"profit" for the purpose of taxation. One major difference is the treatment of depreciation.
Our definition of profit deducts the current value of depreciation as a cost. That is, it
bases depreciation on how much it would cost today to replace worn out capital. By
contrast, under the corporate tax laws, firms deduct depreciation using historical cost.
That is, the depreciation deduction is based on the price of the capital when it was
originally purchased. In periods of inflation, replacement cost is greater than historical
cost, so the corporate tax tends to understate the cost of depreciation and overstate profit.
As a result, the tax law sees a profit and levies a tax even when economic profit is zero,
which makes owning capital less attractive. For this and other reasons, many economists
believe that the corporate income tax discourages investment.
The investment tax credit is a tax provision that encourages the accumulation of capital.
The investment tax credit reduces a firm's taxes by a certain amount for each dollar spent
on capital goods. Because a firm recoups part of its expenditure on new capital in lower
taxes, the credit reduces the effective purchase price of a unit of capital P K. Thus, the
investment tax credit reduces the cost of capital and raises investment.
The Stock Market and Tobin's Q
Many economists see a link between fluctuations in investment and fluctuations in the
stock market. 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. Stock prices tend to be
high when firms have many opportunities for profitable investment, since these profit
opportunities mean higher future income for the shareholders. Thus, stock prices reflect
the incentives to invest.
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:
Market value of installed capital
Q = Re plecement Cost of Installed Capital
Market Value of Installed Capital - value of the economy's capital as determined by the
stock market.

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Replacement Cost of Installed Capital - the price of the capital if it were purchased today.
Tobin reasoned that net investment should depend on whether q is greater or less than
one.
The connection of Tobin's q with neoclassical model comes from the observation that
Tobin's q depends on current and future expected profits from installed capital. If the
MPK exceeds the cost of capital, then installed capital is earning profits. These profits
make the rental firms desirable to own capital, which raises the market value of these
firms' stock, implying a high value of q. Similarly, if the MP K falls short of the cost of
capital, then installed capital is incurring losses, implying a low market value and a low
value of q.
The advantage of Tobin's q as a measure of the incentive to invest is that it reflects the
expected future profitability of capital as well as the current profitability. a reduction in
the corporate income tax beginning next year. This expected fall in the corporate tax
implies greater profits for the owners of capital. These higher expected profits raise the
value of stock today, raise Tobin's q, and therefore encourage investment decisions
depend not only on current economic policies, but also on policies expected to prevail in
the future.
Tobin's q theory provides a simple way of interpreting the role of the stock market in the
economy. Suppose, for example, that you observe a fall in stock prices. Because the
replacement cost of capital is fairly stable, a fall in the stock market usually implies a fall
in Tobin's q. A fall in q reflects investors' pessimism about the current or future
profitability of capital. According to q theory, the fall in q will lead to a fall in
investment, which could lower aggregate demand. In essence, q theory gives a reason to
expect fluctuations in the stock market to be closely tied to fluctuations in output and
employment.
Financing Constraints
When a firm wants to invest in new capital, such as building a new factory, it often raises
the necessary funds in financial markets. This financing may take several forms-obtaining
loans from banks, selling bonds to the public, or selling shares in future profits on the
stock market. The neoclassical model assumes that if a firm is willing to pay the cost of
capital, the financial markets will make the funds available.

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Yet sometimes firms face financing constraints - limits on the amount they can raise in
financial markets. Financing constraints can prevent firms from undertaking profitable
investments. When a firm is unable to raise funds in financial markets, the amount it can
spend on new capital goods is limited to the amount it is currently earning. Financing
constraints influence the investment behavior of firms just as borrowing constraints
influence the consumption behavior of households.
To see the impact financing constraints, consider the effect of a short recession on
investment spending. That is, a short recession will have only a small effect on Tobin's q.
For firms that can rise funds in financial markets, the recession should have only a small
effect on investment.
Quite the opposite is true for firms that face financing constraints. The fall in current
profits restricts the amount that these firms can spend on new capital goods and may
prevent them from making profitable investments. Financing constraints make investment
more sensitive to current economic conditions.
2.2 Residential Investment
In this section we consider the determinants of residential investment.
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. To keep things simple,
however, it is useful to imagine that all housing is owner-occupied.
The stock equilibrium and the flow supply
There are two parts to the model. First, the market for the existing stock of houses
determines the equilibrium housing price. Second, the housing price determines the flow
of residential investment.
The relative price of housing PH/P is determined by the supply and demand for the
existing stock of houses. At any point in time, the supply of houses is fixed. The relative
price of housing determines the supply of new houses. Construction firms buy materials
and hire labor to build houses, and then sell the houses at the market price. Their costs
depend on the overall price level P, and their revenue depends on the price of houses P H.
The higher the relative price of housing, the greater the incentive to build houses and the
more houses are built. The flow of new houses-residential investment-therefore depends
on the equilibrium price set in the market for existing houses.

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This model of residential investment is closely related to the q theory of business fixed
investment. According to q theory, business fixed investment depends on the market
price of installed capital relative to its replacement cost; this relative price, in turn,
depends on the expected profits from owning installed capital. According to this model of
the housing market, residential investment depends on the relative price of housing. The
relative price of housing, in turn, depends on the demand for housing, which depends on
the imputed rent that individuals expect to receive from their housing. Hence, the relative
price of housing plays much the same role for residential investment as Tobin's q does for
business fixed investment.

Changes in Housing Demand

When the demand for housing shifts, the equilibrium housing price changes, which in
turn affects residential investment. The demand curve for housing can shift for various
reasons. An economic boom raises national income and therefore the demand for
housing. A large increase in the population, perhaps due to immigration, also raises the
demand for housing. The fig. shows that an expansionary shift in demand raises the
equilibrium price. And the second fig. shows that the increase in the housing price
increases residential investment.
One of the most important determinants of housing demand is the real interest rate. Many
people take out loans-mortgages-to buy their homes; the interest rate is the cost of the
loan. Even the few people who do not have to borrow to purchase a home will respond to

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the interest rate, because the interest rate is the opportunity cost of holding their wealth in
housing rather than putting it in a bank. A reduction in the interest rate therefore raises
housing demand, housing prices, and residential investment.

The Tax Treatment of Housing

Just as the tax laws affect the accumulation of business fixed investment, they affect the
accumulation of residential investment. In this case, however, their effects are nearly the
opposite. Rather than discouraging investment, as the corporate income tax does for
business, the personal income tax encourages households to invest in housing.

2.3 Inventory Investment

Inventory investment is one of the smallest components of spending, averaging about 1%
of GDP. Yet its remarkable volatility makes it important. In recessions, inventory
investment becomes negative because firms stop replenishing their inventory as goods
are sold. In a typical recession, more than half the fall in spending comes from a decline
in inventory investment.
Reasons for Holding Inventories
Inventories serve many purposes. Before presenting a model to explain fluctuations in
inventory investment, let's discuss some of the motives firms have for holding
inventories.
One use of inventories is to smooth the level of production over time. Consider a firm
that experiences temporary booms and busts in sales. Rather than adjusting production to
match the fluctuations in sales, it may be cheaper to produce goods at a steady rate. When
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sales are low, the firm produces more than it sells and puts the extra goods into inventory.
When sales are high, the firm produces less than it sells and takes goods out of inventory.
This motive for holding inventories is called production smoothing.
A second reason for holding inventories is that they may allow a firm to operate more
efficiently. Retail stores, for example, can sell merchandise more effectively if they have
goods on hand to show to customers. Manufacturing firms keep inventories of spare parts
in order to reduce the time that the assembly line is shut down when a machine breaks. In
some ways, we can view inventories as a factor of production: the larger the stock of
inventories a firm holds, the more output in can produce.
A third reason for holding inventories is to avoid running out of goods when sales are
unexpectedly high. Firms often have to make production decisions before knowing how
much customers will demand. For example, a publisher must decide on how many copies
of a new book to print before knowing whether the book will be popular. If demand
exceeds production and there are no inventories, the good will be out of stock for a
period, and the firm will lose sales and profit. Inventories can prevent this from
happening. This motive for holding inventories is called stock-out avoidance.
A fourth explanation of inventories is dictated by the production process. Many goods
require a number of steps in production and, therefore, take time to produce. When a
product is only partly completed, its components are counted as part of a firm's inventory.
These inventories are called work in process.
The Accelerator Model of Inventories
Because there are many motives for holding inventories, there are many models of
inventory investment. One simple model that explains the data well, without endorsing a
particular motive, is the accelerator model. This model was developed about half a
century ago, and it is sometimes applied to all types of investment. Here we apply it to
the type for which it works best-inventory investment.
The accelerator model of inventories assumes that firms hold a stock of inventories that is
proportional to the firms' level of output. There are various reasons for this assumption.
When output is high, manufacturing firms need more materials and supplies on hand, and
they have more goods in the process of being completed. When the economy is booming,
retail firms want to have more merchandise on the shelves to show customers. This
assumption implies that if N is the stock of inventories and Y is output, then,
N = BY,
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 change in N.
Therefore, I = Δ N = B Δ Y.

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The accelerator model predicts that inventory investment will be proportional to the
change in output. When output rises, firms want to hold more inventories, so they invest
in them. When output falls, firms want to hold fewer inventories, so they allow their
inventories to run down.
We can now see how the model earned its name. Because the variable Y is the rate at
which firms are producing goods, Δ Y is the "acceleration" of production. The model
says that inventory investment depends on whether the economy is speeding up or
slowing down.
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 real 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. For example, in the 1980s many firms adopted "just-in-time"
production plans, which were designed to reduce the amount of inventory by producing
goods just before sale. The high real interest rates that prevailed during most of this
decade are one possible explanation for this change in business strategy.
Conclusion
The purpose of this chapter has been to examine the determinants of investment in more
detail. Looking back on the various models of investment, three themes arise.
First, we have seen that all types of investment spending are inversely related to the real
interest rate. A higher interest rate raises the cost of capital to firms that invest in plant
and equipment, raises the cost of borrowing to home-buyers, and raises the cost of
holding inventories. Thus, the models of investment developed here justify the
investment function we have used throughout this book.
Second, we have seen what can cause the investment function to shift. An improvement
in the available technology raises the MP K and raises business fixed investment. An
increase in the population raises the demand for housing and raises residential
investment. Most important, various economic policies, such as changes in the
investment tax credit and the corporate income tax, alter the incentives to invest and thus
shift the investment function.
Third, we have learned why investment is so volatile over the business cycle: investment
spending depends on the output of the economy as well as on the interest rate. In the
neoclassical model of business fixed investment, higher employment raises the MP K and
the incentive to invest. Higher income also raises the demand for houses, which raises
housing prices and residential investment. Higher output raises the stock of inventories
firms wish to hold, stimulating inventory investment. Our models predict that an

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economic boom should stimulate investment, and a recession should depress it. This is
exactly what we observe.

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