The Theory of Investment

The Theory of Investment

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Description: 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.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, material, and supplies, and work in progress.

 
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Contents:
CHAPTER

17

The Theory of Investment

Modified for ECON 2204
by Bob Murphy
© 2016 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

1

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

2

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

Billions of current dollars

3000

Total investment
Business fixed investment
Residential investment
Change in inventories

2500
2000
1500
1000
500
0
-500
1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

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

4

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

5

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

The Theory of Investment

capital
supply

capital
demand
(MPK)

K

K
capital
stock
6

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

α

1−α

Y = AK L

R
= MPK = α A (L K
P

)

1−α

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

7

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

8

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

9

The cost of capital

Nominal cost
ΔPK ⎞
= i PK + δ PK − ΔPK = PK ⎜ i + δ −

of capital
PK ⎠

Example: car rental company (capital: cars)
Suppose PK = $10,000, i = 0.10, δ = 0.20,
and ΔPK/PK = 0.06
Then,

CHAPTER 17

interest cost = $1000
depreciation cost = 2000
capital loss = −600
total cost = $2400
The Theory of Investment

10

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

PK
and the real cost of capital equals
(r + δ )
P
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

11

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

PK
PK
R
Profit rate =

(r + δ ) = MPK −
(r + δ )
P
P
P

§ 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

12

Net investment & gross investment
Hence,

net investment = ΔK = I n ⎡MPK − (PK P )(r + δ )⎤


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:

gross investment = ΔK + δ K
= I n ⎡MPK − (PK P )(r + δ )⎤ + δ K


CHAPTER 17

The Theory of Investment

13

The investment function
I = I n ⎡MPK − (PK P )(r + δ )⎤ + δ K


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

r

r2
r1
I2

CHAPTER 17

The Theory of Investment

I1

I
14

The investment function
I = I n ⎡MPK − (PK P )(r + δ )⎤ + δ K


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

r

r1

The Theory of Investment

I1

I2

I
15

Taxes and investment
Two of the most important tax policies
affecting investment:
1. Corporate income tax
2. Investment tax credit

CHAPTER 17

The Theory of Investment

16

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

17

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

18

Tobin’s q
Market value of installed capital
q =
Replacement cost of installed capital

§ 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

19

Relation between q theory and
neoclassical theory
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

The Theory of Investment

20

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

21

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

22

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

23

The stock market and GDP
Percent 60
change
from
40
1 year
earlier

9

Real GDP (right scale)

Percent
change
from
6
1 year
earlier

20

3

0

0

-20

-3

-40

-6

Stock prices (left scale)
-60
1970

1975

1980

1985

1990

1995

2000

2005

2010

-9
2015

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

25

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

26

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

27

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

28

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

29

How residential investment is determined
(a) The market for housing

PH
P

Supply

Supply and demand for
houses determines the
eq’m price of houses.

Demand
KH

The equilibrium price of
houses then determines
residential investment:

Stock of
housing capital
CHAPTER 17

The Theory of Investment

30

How residential investment is determined
(a) The market for housing (b) The supply of new housing

PH
P

PH
P

Supply

Demand
KH

Stock of
housing capital
CHAPTER 17

The Theory of Investment

Supply

IH
Flow of residential
investment
31

How residential investment responds to a
fall in interest rates
(a) The market for housing (b) The supply of new housing

PH
P

PH
P

Supply

Demand
KH

Stock of
housing capital
CHAPTER 17

The Theory of Investment

Supply

IH
Flow of residential
investment
32

U.S. Housing Prices and Housing Starts,
2000-2014

200

2,000

150

1,500

100

1,000

Housing prices
(left scale)

50

500

Housing starts
(right scale)
2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

0
2001

0

Housing Starts (thousands)

2,500

2000

Housing Price Index
= 100 in 2000 1st quarter

250

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

The Theory of Investment

34

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

35

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

36

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

37

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

38

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

39

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.

40

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.

41