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1、Investment,17,CHAPTER 17 Investment,In this chapter,you will learn,leading theories to explain each type of investmentwhy investment is negatively related to the interest ratethings that shift the investment functionwhy investment rises during booms and falls during recessions,CHAPTER 17 Investment,
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 an
3、d supplies,and work in progress.,CHAPTER 17 Investment,U.S.investment and its components,Billions of 1996 dollars,-250,0,250,500,750,1000,1250,1500,1750,2000,1970,1975,1980,1985,1990,1995,2000,2005,CHAPTER 17 Investment,Understanding business fixed investment,The standard model of business fixed inv
4、estment:the neoclassical model of investmentShows how investment depends onMPKinterest ratetax rules affecting firms,CHAPTER 17 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
5、,rent it to production firms.,In this context,“investment”is the rental firms spending on new capital goods.,CHAPTER 17 Investment,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.,equilibrium
6、 rental rate,CHAPTER 17 Investment,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:K(e.g.,earthquake or war)L(e.g.,pop.growth or immigration)A(technological improvement,or deregulation),CHAPTER 1
7、7 Investment,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,The cost of capital,Componen
8、ts of the cost of capital:interest cost:i PK,where PK=nominal price of capitaldepreciation cost:PK,where=rate of depreciationcapital 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,Then,interest cost=depreciation cost=cap
9、ital loss=total cost=,The cost of capital,Example:car rental company(capital:cars)Suppose PK=$10,000,i=0.10,=0.20,and PK/PK=0.06,Nominal cost of capital,$1000,$2000,$600,$2400,CHAPTER 17 Investment,The cost of capital,For simplicity,assume PK/PK=.Then,the nominal cost of capital equals PK(i+)=PK(r+)
10、and the real cost of capital equals,The real cost of capital depends positively on:the relative price of capitalthe real interest ratethe depreciation rate,CHAPTER 17 Investment,The rental firms profit rate,A firms net investment depends on its profit rate:,If profit rate 0,then increasing K is prof
11、itableIf 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,Net investment&gross investment,Hence,where In is a function that shows how net investment responds to the incentive to invest.Total spen
12、ding on business fixed investment equals net investment plus replacement of depreciated K:,CHAPTER 17 Investment,The investment function,An increase in r raises the cost of capital reduces the profit rate and reduces investment:,I2,r2,CHAPTER 17 Investment,The investment function,An increase in MPK
13、or decrease in PK/P increases the profit rate increases investment at any given interest rateshifts I curve to the right.,CHAPTER 17 Investment,Taxes and investment,Two of the most important taxes affecting investment:Corporate income taxInvestment tax credit,CHAPTER 17 Investment,Corporate Income T
14、ax: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 investmentBut,the legal definition uses the historical price of capital.If PK rises
15、 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,The Investment Tax Credit(ITC),The ITC reduces a firms taxes by a certain am
16、ount for each dollar it spends on capital.Hence,the ITC effectively reduces PKwhich increases the profit rate and the incentive to invest.,CHAPTER 17 Investment,Tobins q,numerator:the stock market value of the economys capital stock.denominator:the actual cost to replace the capital goods that were
17、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,Relation between q theory and neoclassical theory described above,The stock market value of capital depends on the cur
18、rent&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,The
19、stock market and GDP,Reasons for a relationship between the stock market and GDP:,1.A wave of pessimism about future profitability of capital wouldcause stock prices to fallcause Tobins q to fall shift the investment function downcause a negative aggregate demand shock,CHAPTER 17 Investment,The stoc
20、k market and GDP,Reasons for a relationship between the stock market and GDP:,2.A fall in stock prices wouldreduce household wealthshift the consumption function downcause a negative aggregate demand shock,CHAPTER 17 Investment,The stock market and GDP,Reasons for a relationship between the stock ma
21、rket 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,The stock market and GDP,Percent change
22、from 1 year earlier,Percent change from1 year earlier,-30,-20,-10,0,10,20,30,40,50,1970,1975,1980,1985,1990,1995,2000,2005,-6,-4,-2,0,2,4,6,8,10,CHAPTER 17 Investment,Alternative views of the stock market:The Efficient Markets Hypothesis,Efficient Markets Hypothesis(EMH):The market price of a compan
23、ys 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
24、),and should only change as new information arrives.,CHAPTER 17 Investment,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
25、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,Alternative views of the s
26、tock 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,Financing constraints,Neoclassical theory assumes firms can borrow to
27、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 co
28、nstraints and current profits are low,firm might be unable to obtain funds.,CHAPTER 17 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 Investme
29、nt,How residential investment is determined,KH,(a)The market for housing,Supply and demand for houses determines the equilib.price of houses.,Supply,The equilibrium price of houses then determines residential investment:,Stock of housing capital,CHAPTER 17 Investment,How residential investment is de
30、termined,KH,IH,Supply,(a)The market for housing,(b)The supply of new housing,Supply,Stock of housing capital,Flow of residential investment,CHAPTER 17 Investment,How residential investment responds to a fall in interest rates,KH,IH,Supply,Supply,Stock of housing capital,Flow of residential investmen
31、t,(a)The market for housing,(b)The supply of new housing,CHAPTER 17 Investment,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
32、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 capitalBut eliminating the mortgage interest deduction would be politically difficult.,CHAPTER 17 Investment,Inventory investment,Inventory investmen
33、t 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,Motives for holding inventories,1.production smoothingSales fluctuate,but many firms find it cheaper to produce at a steady rate.When sales pro
34、duction,inventories fall.,CHAPTER 17 Investment,Motives for holding inventories,1.production smoothing2.inventories as a factor of productionInventories allow some firms to operate more efficiently.samples for retail sales purposesspare parts for when machines break down,CHAPTER 17 Investment,Motive
35、s for holding inventories,1.production smoothing2.inventories as a factor of production3.stock-out avoidanceTo prevent lost sales when demand is higher than expected.,CHAPTER 17 Investment,Motives for holding inventories,1.production smoothing2.inventories as a factor of production3.stock-out avoida
36、nce4.work in processGoods not yet completed are counted in inventory.,CHAPTER 17 Investment,The Accelerator Model,A simple theory that explains the behavior of inventory investment,without endorsing any particular motive,CHAPTER 17 Investment,The Accelerator Model,Notation:N=stock of inventoriesN=in
37、ventory investmentAssume:Firms hold a stock of inventories proportional to their outputN=Y,where is an exogenous parameter reflecting firms desired stock of inventory as a proportion of output.,CHAPTER 17 Investment,The Accelerator Model,Result:N=Y Inventory investment is proportional to the change
38、in output.When output is rising,firms increase inventories.When output is falling,firms allow their inventories to run down.,CHAPTER 17 Investment,Evidence for the Accelerator Model,Inventory investment(billions of 1996 dollars),Change in real GDP(billions of 1996 dollars),-40,-20,0,20,40,60,80,100,
39、-200,-100,0,100,200,300,400,500,CHAPTER 17 Investment,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 i
40、nterest rates in the 1980s motivated many firms to adopt just-in-time production,which is designed to reduce inventories.,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 busin
41、ess 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 44,Chapter Summary,Investment is the most volatile component of GDP ov
42、er 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 45,
