Chapter One: Theories of Investment

Macroeconomics II
Econ 212
November, 2020
Dechu T.(Msc)
Introduction
 Economists study investment to better understand
fluctuations in the economy’s output of goods and
services.
 The models of GDP we saw in previous chapters, such
as the IS–LM model in Chapters was based on a simple
investment function relating investment to the real
interest rate: I = I(r).
 That function states that an increase in the real interest
rate reduces investment.
 In this chapter we look more closely at the theory behind
this investment function.
Introduction……Con’t

 There are three 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 process, and finished goods.
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.
There are two kinds of firms in the economy.
1. Production firms produce goods and services using capital that
they leased in.
2. Rental firms make all the investments in the economy; they
buy capital and lease it out to the production firms.
THE RENTAL PRICE OF CAPITAL
/PRODUCTION FIRM/
 The firm leases (contracts) 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.
 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 RENTAL PRICE OF CAPITAL
/PRODUCTION FIRM/……
 The Cobb-Douglas production function is Y = AKaL1-a
 Where, Y is output, K capital, L labor, A is a parameter

measuring the level of technology, and A is a parameter

between zero and one that measures capital's share of
output.
 The MPK 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
THE RENTAL PRICE OF CAPITAL
/PRODUCTION FIRM/……
 The Cobbm 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.
THE COST OF CAPITAL /RENTAL FIRM/

 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 PK 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 - ∆ PK.
THE COST OF CAPITAL /RENTAL FIRM/….

 3. If  is the rate of depreciation-the fraction of value

lost per period due to wear and tear-then the dollar cost
of depreciation is PK.
 Cost of Capital = iPK -  PK +  PK
 = PK(i -  PK /PK +  )
 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.
THE COST OF CAPITAL /RENTAL FIRM/….

 For example, consider the cost of capital to a car-rental

company. The company buys cars at $10000 each and rents
them out to other business.
 The company faces an interest rate I of 10% per year, so the
interest cost iPK is $1000 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 ∆ PK of $600 per year.
 Car depreciate at 20% per year, so the loss due to wear and tear
 PK is $2000 per year.
 Therefore, the company's cost of capital is Cost of Capital =
$1,000 - $600 + $2000 =$2400
THE COST OF CAPITAL /RENTAL FIRM/….

 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,  PK /PK equals the overall rate of

inflation  . Because i -  equals the real interest

rate r, we can write the cost of capital as
 Cost of Capital = PK(r +  )
THE COST OF CAPITAL /RENTAL FIRM/….

 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 +  )
 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
rate  .
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 + ).

The real profit per unit of capital is
 Profit Rate = Revenue - Cost

 Profit rate = R/P - (PK/P)(r +  )

 Since the real rental price in equilibrium equals

the MPK, we can write the profit rate as

 Profit Rate = MPK - (PK/P)(r +  )
THE DETERMINANTS OF INVESTMENT….

 The rental firm makes a profit if the MP K is

greater than the cost of capital.
 It incurs aloss if the MP K is less than the cost of

capital.
  K = In (MPK - (PK/P)(r +  ))
 We can now derive the, I 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 +  )) +  K.

 Replacement of depreciated capital.

TAXES AND INVESTMENT

 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
 The investment tax credit is a tax provision that
encourages the accumulation of capital.
THE STOCK MARKET AND TOBIN'S Q

 Tobin's
  q theory provides a simple way of interpreting the
role of the stock market in the economy
 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 - value of the economy's

capital as determined by the stock market.
 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 STOCK MARKET AND TOBIN'S Q….

 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.
 For example, suppose that the government legislates 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.
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.
 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….

 Financing constraints influence the investment behavior

of firms just as borrowing constraints influence the
consumption behavior of households.
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

 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.
 Their costs depend on the overall price level P, and their
revenue depends on the price of houses PH.
 The higher the relative price of housing, the greater the
incentive to build houses, and the more houses are built.
The stock equilibrium and the flow supply…..

 This model of residential investment is closely related to

the q theory of 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.
 One of the most important determinants of housing
demand is the real interest rate
CHANGES IN HOUSING DEMAND…

 The fig. shows that an expansionary shift in demand

raises the equilibrium price.
 The second fig. shows that the increase in the housing
price increases 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.
INVENTORY INVESTMENT

 Inventory investment is one of the smallest components

of spending, averaging about 1% of GDP.
 Reasons for Holding Inventories

1. One use of inventories is to smooth the level of

production over time.
 Consider a firm that experiences temporary booms and

busts in sales.
2. 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
Reasons for Holding Inventories

 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.
 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

 The accelerator model of inventories assumes that firms

hold a stock of inventories that is proportional to the
firms' level of output.
 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 =  N = B  Y.
Inventories and the Real interest rate

 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 depress
 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
thisdecade are one possible explanation for this change
The End

 .

f o r
u
o ionr
k y t
h a n t te n
T ur a
yo
Chapter-3
Supply and Demand for Money

 . 3.1 Supply of Money

 The quantity of money supply in an economy is defined
simply as the value of currencies
 held by the public, and the Central Banks control the
supply of money by increasing or decreasing
 the quantity of currency in circulation through open
market operations. But this definition of money
 supply omits the banking sector. Money supply includes
the currency in the hands of the public and
 the deposits at banks that households can use on demand
for transactions, such as checking accounts.