1

Investment
7

CHAPTE
R

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint Slides by Ron Cronovich
2007 Worth Publishers, all rights reserved

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 Investment

slide 2

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 Investment

slide 3

U.S. investment and its

components
Billions 2000
of 1996 1750
dollars
1500
1250

Total investment
Business fixed investment
Residential investment
Change in inventories

1000
750
500
250
0
-250
1970

1975

CHAPTER 17 Investment

1980

1985

1990

1995

2000

2005
slide 4

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 Investment

slide 5

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 Investment

slide 6

The capital rental market

Production firms
must decide how
much capital to rent.

real rental
price, R/P

Recall from Chap. 3:

Competitive firms
rent capital to the
point where
equilibrium
MPK = R/P.
rental rate

CHAPTER 17 Investment

capital
supply

capital
demand
(MPK)

K
capital
stock
slide 7

Factors that affect the rental

price
For the Cobb-Douglas
production function,
the MPK (and hence
equilibrium R/P ) is

Y AK L1
R
1
MPK A L K
P

The equilibrium R/P would increase if:

K (e.g., earthquake or war)

L (e.g., pop. growth or immigration)
A (technological improvement, or deregulation)
CHAPTER 17 Investment

slide 8

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 Investment

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The cost of capital

Components of the cost of capital:
interest cost: i PK,
where PK = nominal price of capital
depreciation cost: PK,
where = rate of depreciation
capital loss: PK
(a capital gain, PK > 0, reduces cost of K )
The total cost of capital is the sum of these
three parts:
CHAPTER 17 Investment

slide 10

The cost of capital

PK
Nominal cost
i PK PK PK PK i

of capital
P

Example: car rental company (capital: cars)

Suppose PK = $10,000, i = 0.10, = 0.20,
and PK/PK = 0.06
Then, interest cost =
depreciation cost =
capital loss =
total cost =
CHAPTER 17 Investment

$1000
$2000
$600
$2400
slide 11

The cost of capital

For simplicity, assume PK/PK = .
Then, the nominal cost of capital equals
PK(i + ) = PK(r + )
PK
and the real cost of capital equals
r
P

The real cost of capital depends positively on:

the relative price of capital

the real interest rate
the depreciation rate
CHAPTER 17 Investment

slide 12

The rental firms profit rate

A firms 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.
(Firm reduces K by not replacing it as it depreciates.)
CHAPTER 17 Investment

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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 Investment

slide 14

The investment function

An increase in r
raises the cost
of capital
reduces the
profit rate
and reduces
investment:

r2
r1
I2

CHAPTER 17 Investment

I1

I
slide 15

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.
CHAPTER 17 Investment

r1
I1

I2

I
slide 16

Taxes and investment

Two
Two of
of the
the most
most important
important taxes
taxes
affecting
affecting investment:
investment:

1.
1. Corporate
Corporate income
income tax
tax
2.
2. Investment
Investment tax
tax credit
credit

CHAPTER 17 Investment

slide 17

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 Investment

slide 18

The Investment Tax Credit

(ITC)

The ITC reduces a firms 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 Investment

slide 19

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

numerator: the stock market value of the economys

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 Investment

slide 20

Relation between q theory and

neoclassical theory described
above
Market value of installed capital
q

Replacement cost of installed capital

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 Investment

slide 21

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 Tobins q to fall
shift the investment function down
cause a negative aggregate demand
shock
CHAPTER 17 Investment

slide 22

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 Investment

slide 23

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 Investment

slide 24

The stock market and GDP

Percent
change
from
1 year
earlier

50

Real GDP (right scale)

10

40

30

20

10

-10

-2

-20

-4

-30
1970

Stock prices (left scale)

1975

1980

CHAPTER 17 Investment

1985

1990

1995

2000

Percent
change
from
1 year
earlier

-6
2005

slide 25

Alternative views of the stock

market: The Efficient Markets
Hypothesis

Efficient Markets Hypothesis (EMH):

The market price of a companys stock is the fully

rational valuation of the company,
given current information about the companys
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 Investment

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Alternative views of the stock

market: Keyness beauty
contest

Idea based on newspaper beauty contest in which

a reader wins a prize if he/she picks the women
most frequently selected by other readers as
most beautiful.

Keynes proposed that stock prices reflect peoples

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 Investment

slide 27

Alternative views of the stock

market: EMH vs. Keyness beauty
contest
Both views persist.

There is evidence for the EMH and random-walk

theory (see p.498).

Yet, some stock market movements do not seem

to rationally reflect new information.

CHAPTER 17 Investment

slide 28

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 Investment

slide 29

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 Investment

slide 30

How residential investment is

determined
(a) The market for housing
PH
P

Suppl
y

Supply
Supply and
and demand
demand for
for
houses
houses determines
determines the
the
equilib.
equilib. price
price of
of houses.
houses.

Demand
KH
Stock of
housing capital
CHAPTER 17 Investment

The
The equilibrium
equilibrium price
price of
of
houses
houses then
then determines
determines
residential
residential investment:
investment:

slide 31

How residential investment is

determined
(a) The market for housing (b) The supply of new housing
PH
P

Suppl
y

Demand
KH
Stock of
housing capital
CHAPTER 17 Investment

PH
P

Suppl
y

IH
Flow of residential
investment
slide 32

How residential investment

responds to a fall in interest rates
(a) The market for housing (b) The supply of new housing
PH
P

Suppl
y

Demand
KH
Stock of
housing capital
CHAPTER 17 Investment

PH
P

Suppl
y

IH
Flow of residential
investment
slide 33

The tax treatment of housing

The tax code, in effect, subsidizes home ownership

by allowing people to deduct mortgage interest.

The deduction applies to the nominal mortgage rate,

so this subsidy is higher when inflation and nominal
mortgage rates are high than when they are low.

Some economists think this subsidy causes

over-investment in housing relative to other forms of
capital

But eliminating the mortgage interest deduction

would be politically difficult.
CHAPTER 17 Investment

slide 34

Inventory investment

Inventory investment is only about

1% of GDP.
Yet, in the typical recession,
more than half of the fall in spending
is due to a fall in inventory investment.

CHAPTER 17 Investment

slide 35

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 Investment

slide 36

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 Investment

slide 37

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 Investment

slide 38

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 Investment

slide 39

The Accelerator Model

A simple theory that explains
the behavior of inventory investment,
without endorsing
any particular motive

CHAPTER 17 Investment

slide 40

The Accelerator Model

Notation:
N = stock of inventories
N = inventory investment

Assume:
Firms hold a stock of inventories proportional
to their output
N = Y,
where is an exogenous parameter
reflecting firms desired stock of inventory
as a proportion of output.
CHAPTER 17 Investment

slide 41

The Accelerator Model

Result:
N = Y
Inventory investment is proportional to the
change in output.

When output is rising,

firms increase inventories.

When output is falling,

firms allow their inventories to run down.

CHAPTER 17 Investment

slide 42

Evidence for the Accelerator

Model

Inventory 100
investment
80
(billions of
1996 60
dollars)
40

1998
1967

1978

1974

1996

20
0
-20
-40
-200

1984

2004

1983
1982
-100

2001
0

100

200

300

400

500

Change in real GDP (billions of 1996 dollars)

CHAPTER 17 Investment

slide 43

Inventories and the real interest

rate

The opportunity cost of holding goods in

inventory: the interest that could have been
earned on the revenue from selling those goods.

Hence, inventory investment depends on

the real interest rate.

Example:
High interest rates in the 1980s motivated many
firms to adopt just-in-time production, which is
designed to reduce inventories.
CHAPTER 17 Investment

slide 44

Chapter Summary
1. All types of investment depend negatively on the

real interest rate.

2. 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

Investment

slide 45

Chapter Summary
3. 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

Investment

slide 46