CHAPTER SIX: THE THEORY OF INVESTMENT

CHAPTER SIX: THE THEORY OF INVESTMENT

This chapter is devoted to the theory of investment. Why? Because investment is an

important determinant for:

 Long run growth (through the role of capital formation)

 Business cycle dynamics
Chapter Objectives:
At the end of this chapter, you will be able to:
 Understand the notion and categories of investment
 Appreciate the r/ship b/n investment spending, capital stock and output/growth
 Identify and elaborate the implications of the leading Theories of investment
 Identify the factors which shifts investment function
 Explain why investment rises during expansion and falls during recessions

6.1. INTRODUCTION: Investment versus Capital Stock

What is investment?
Strictly speaking, investment is the change in capital stock during a period. It is the
formation of real capital, tangible or intangible, that will produce a stream of goods
and services in the future.
Consequently, unlike capital, investment is a flow concept and not a stock concept .
This means that while capital is measured at a point in time (eg: the given dollar
value of all the buildings, machines, and inventories at a point in time.), investment can
only be measured over a period of time (i.e., investment is the flow of spending that adds
to the physical stock of capital).
o Investment spending is aimed at providing a higher standard of income in the future. Thus,
investment links the present to the future.
 Investment Affects Future Output via Rising the stock of Capital
o The capital stock is a very important input used to produce output and the level of
investment ultimately determines the level of the capital stock and thus the growth of output.
 The r/ship b/n investment and the capital stock can be expressed in the following way:
= + −
Where

MACROECONOMICS AMU 1
 CHAPTER SIX: THE THEORY OF INVESTMENT

= stock of capital at time t.

= Gross investment at time t.
= the depreciation rate.
 Another way of stating this relationship is looking at the net change in the capital stock,
expressed as;
− = − = ,

where , is net investment at time t.

This implies that if , increases then will increase and thus + > , that is,
output should increase.
 Note that the notation used above assumes that investment undertaken today does not really
become productive until the future.
o Investment can be undertaken not only by firms or households, but also by the government.
For example, looking at Business Fixed Investment of different countries, government sector
undertakes significant proportion of this category.
o Investment makes up about 20% of GDP, and although obviously not as large as
consumption it is important because investment over long periods determines the size of the
stock of capital and thus helps determine long-run growth.
o Investment spending is very volatile and thus responsible for much of the fluctuations of GDP
across the business cycle.
 As a result, understanding what factors affect investment is crucial not only because
it is part of GDP but b/c it is crucial in determining fluctuations and growth in GDP.
o In this chapter, therefore, we first examine the components of investment and then study
what determines investment by referring to the leading theories of investment.

6.2. TYPES /CATEGORIES/ OF INVESTMENT

 Investment undertaken in an economy is classified according to the following three major

categories:
Business fixed investment indicates the annual increase in equipment, machineries and
structures/ plant, office buildings, etc/ by businesses used in production.
Residential Construction investment-investment in new housing units by people to live in
and/or by landlords to rent out.
Inventory investment includes those goods that businesses put aside in storage, including
materials and supplies, work in progress, and finished goods.

MACROECONOMICS AMU 2
 CHAPTER SIX: THE THEORY OF INVESTMENT

6.3. MODELS OF INVESTMENT

We have noted above that investment fluctuates too much, and this fluctuation in investment can
be a proximate source of fluctuation in output both in the short-run and in the long-run. In this
section, therefore, we build models of each type of investment to explain these fluctuations in
investment spending and thereby output.
6.3.1. BUSINESS FIXED INVESTMENT
 The largest piece of investment spending, accounting for about three-quarters of the total
is business fixed investment.
 Business fixed investment includes everything from fax machines to factories, computers
to company cars.

6.3.1.1. The Neoclassical Model Of Business Fixed Investment

 The Neoclassical model of investment is the standard model of business fixed investment.
 It dates mainly from Jorgensen's papers in the 1960s.
 The model examines the benefits and costs of owning capital goods.
 It shows how the level of investment is related to
 The marginal product of capital,
 The interest rate, &
 The tax rules affecting firms.
To develop the model, assume that there are two types of firms:
i. Production firms rent the capital they use to produce goods and services &
ii. Rental firms own capital, rent it out to production firms.
In this context, investment is the rental firms' spending on new capital goods.
A. The Capital Rental Market
Let’s first consider a typical production firm. The production firm decides how much capital
to rent to maximize its profit which is the excess of revenues over costs.
 It rents capital at a rental rate, and sells its output at a price, ; the real cost of a unit of
capital to the production firm is .
 The real benefit of a unit of capital is the marginal product of capital; – the extra
output produced with one more unit of capital. The Marginal product of capital declines as
the amount of capital rises.
 Therefore, competitive firms rent capital to the point where = . The real rental
price of capital, adjusts to equilibrate the demand for capital (w/c is determined by
the ) and the fixed supply. Note the following figure.

MACROECONO MICS, AMU 3

 CHAPTER SIX: THE THEORY OF INVESTMENT

 curve slopes downwards since

Real rental price, Capital supply as more and more capital is used, the
extra output obtainable from the
extra capital utilized declines.
 The supply curve is vertical because
the existing stock of capital is fixed
at a point in time.

Capital demand ( )

0 Capital stock, K
Fig:6.1: The Capital Rental Market and the decision of a production firm

What determines the real rental price of capital, ?

To see what variables influence the equilibrium rental price, , let’s consider the
Cobb-Douglas production function as a good approximation of how the actual
economy turns capital and labor into goods and services.
 The Cobb-Douglas production function is: = ,
where Y is output, K capital, L labor, and A a parameter measuring the level of
technology, and a parameter between 0 and 1 that measures capital’s share of
output.

 The marginal product of capital for the Cobb-Douglas production function is

= ( / ) .
Because the real rental price equals the marginal product of capital in equilibrium, we
can write / = ( / ) .
This expression identifies the variables that determine the real rental price. It
shows the following:
 The lower the stock of capital, K, the higher the real rental price of capital
 The greater the labor employed, the higher the real rental price of capitals
 The better the technology, the higher the real rental price of capital.
Events that reduce the capital stock (eg: earthquake & war), or raise employment (eg:
expansion in aggregate demand), or improve the technology (a scientific discovery),
raise the equilibrium real rental price of capital.

MACROECONOMICS, AMU 4
 CHAPTER SIX: THE THEORY OF INVESTMENT

B. Rental Firms’ Investment Decision

Rental firms invest in new capital when the benefit exceeds the cost of doing so.

So, let’s consider the benefit and cost of owning capital.

 / - is the benefit of capital rental firms earn from renting a unit of capital to
production firms.
 For each period that a firm rents out a unit of capital, the rental firm bears three
costs:
i. The interest cost: when a rental firm borrows to buy a unit of capital to rent out,
it must pay interest on loan, which equals the purchase price of a unit of capital PK
times the nominal interest rate, i, so . Notice that this interest cost would be the
same even if the rental firm buys capital using cash on hand because it losses the
interest it could have earned by depositing this cash in bank.
ii. Depreciation defined as the fraction of value lost per period because of the wear
and tear while the capital is rented out, so the dollar cost of depreciation is .
iii. Capital Loss: While the rental firm is renting out the capital, the price of capital
may change. If the price of capital rises, the firm gains, because the firm’s asset has
risen in value, and hence this reduces the firm’s cost and vice versa. The cost of the
loss or gain on the price of capital is denoted as −∆ .

Therefore, the total nominal cost of renting out a unit of capital for one
period is: = + − ∆ = ( + −∆ / )

For example, consider the cost of capital to a car-rental company. The company buys
cars for $10,000 each and rents them out to other businesses. The company faces an
interest rate of 10 percent per year. Moreover, car prices are rising at 6 percent per
year and cars depreciate at 20 percent per year. Calculate the company’s nominal
cost of capital?

= 0.1($10,000) + 0.2(10,000) − 0.06(10,000)

=$ +$ −$ =$

MACROECONOMICS AMU 5
 CHAPTER SIX: THE THEORY OF INVESTMENT

To make the expression simple, assume that the price of capital rises with the price of
other goods. Thus, ∆ / equals the overall rate of inflation, . Because − = , we
can write the cost of capital as:

= ( + )

Finally, we want the real cost of capital- the cost of capital relative to the price of
other goods in the economy.

The Real Cost of Capital = ( + ).

Where r is the real interest rate and / equals the relative price of capital.

 This equation states that the real cost of capital positively depends on the
relative price of capital, the real interest rate and the depreciation rate.

Now consider a RENTAL FIRM’S DECISION about whether to

increase/ decrease its capital stock.

For each unit of capital, the firm earns real revenue & bears the real cost
( + ).

Therefore, the real profit per unit of capital is:

Profit rate = Revenue - Cost

= −( / )( + ) or

= − ( + ) , B/c = .

Thus, the change in the capital stock, called net investment on new capital
depends on the difference between the and the real cost of capital or the
profit rate.

 If the > the real cost of capital, the firm is making profits on the
last unit of capital it is using and it could increase profits by investing more on
new capita. In other words, if the profit rate is positive then increasing capital is
profitable.
 If the < real cost of capital, firms let their capital stock shrink.

MACROECONOMICS, AMU 6
 CHAPTER SIX: THE THEORY OF INVESTMENT

 Net Investment & Gross Investment

Now, we can derive the investment function in the Neoclassical model of investment.

= ∆ = – ( + ) ,

where In (.) is the function showing how net investment responds to the incentive to invest.

Total spending on business fixed investment (i.e., gross investment) is the sum of net investment
and the replacement of depreciated capital. The gross investment function, I, therefore, is:

=∆ +

∴ = − ( + ) +

 Business fixed investment depends on the marginal product of capital, the cost of
capital and the amount of depreciation.

This model shows how investment depends on the interest rate. An increase in the real
interest rate raises the cost of capital therefore reduces the amount of profit from
owing capital and reduces the incentive to accumulate more capital, the converse holds
true.

 The investment function is down ward sloping to the interest rate. And an increase
in the marginal productivity of capital shifts the investment function outward at any
given interest rate.

Real interest rate, r

Investment, I
Fig: 2.2: The investment function and marginal productivity of capital

The above figure presents the investment function. Any event that raises the marginal
product of capital / Eg: technological innovation that increases the production

MACROECONOMICS AMU// 7
 CHAPTER SIX: THE THEORY OF INVESTMENT

function parameter A/ increases the profitability of investment and causes the

investment function to shift outward for any given interest rate /i.e., the amount of
capital that rental firms wish to buy increases.

C. Taxes and Investment

Tax laws influence firms’ incentives to accumulate capital in many ways. We can
amend the profit rate relationship we derived above to include the effects of government
taxes. Let τ be the tax rate on firm revenues. Then, the after tax profit rate of
capital is;

= (1 − τ) − ( + )

So we can see that the tax reduces the profits earned from capital by reducing the
Marginal benefit of using and owning capital.
Here we can consider three of the most important tax policies affecting investment:
i. Corporate Income Tax
The Corporate income tax is a tax on corporate profits. An increase in the Corporate
income tax will effectively increase τ and hence decreases profit and thereby investment.
This sort of policy will discourage the accumulation of capital.

ii. Investment Tax Credits

This is a tax provision policy that reduces a firm’s taxes by a certain amount for each
dollar spent on capital goods. This effectively lowers τ, reducing the cost of capital and
causing an increase in investment. This sort of policy will encourage the accumulation
of capital.
iii. Tax Treatment of Depreciation
Corporate profits are taxed and profits are just revenue minus costs. Part of the costs of
production firms is depreciation on capital so that firms are allowed to include
depreciation of their capital as a cost when calculating the amount of profit to be taxed.
But depreciation is calculated using historical cost, not replacement cost which tends
to understates the true cost of depreciation in periods of high inflation, which

MACROECONOMICS, AMU 8
 CHAPTER SIX: THE THEORY OF INVESTMENT

overstates the profits being made. This means a tax is levied even if the economic profit
is zero, which effectively increases τ, reducing investment, and discouraging the
accumulation of capital.
 Summary of Business Fixed Investment
i. Higher interest rate increases the cost of capital and reduces business fixed
investment.
ii. Improvements in technology and tax policies, such as the corporate income tax
and investment tax credit, shift the business fixed investment function.
iii. During booms higher employment increases the and therefore, increases
business fixed investment.

6.3.1.2. The Accelerator Theory Of Business Fixed Investment

The other theory for explaining the level of business fixed investment and why it
behaves as it does is called the accelerator theory of investment.

This theory argues that firms produce output and they need capital to produce this
output. It is likely that a firm has some desired stock of capital in mind when producing
any given amount of output. If the desired capital stock differs from what the firm
actually has, then it must change its capital stock and how much it changes it is the
amount of investment.

The accelerator model begins with an assumption that firms’ desired capital-output
ratio is roughly constant. If output is required to be produced and is capital-output
ratio (which is equal to / ), the required amount of capital to produce output will
be given by the following equation:

= …………………………………………….. ( )

Under the assumption of constant capital-output ratio, changes in output are made
possible by changes in the stock of capital. Thus, when income is as above, then
required stock of capita = . When output or income is equal to then
required stock of capital will be

= ……………………………………… ( )

Hence, the increase in the stock of capital in period is given by the following
equation: − = − ………………………… ( )

Since increase in the stock of capital in a year ( − ) represents investment in that

year ( ), the above equation can be written as:

MACROECONOMICS, AMU 9
 CHAPTER SIX: THE THEORY OF INVESTMENT

− = ( − );

Where, ∆ = − = & ∆ = −

Therefore, = ∆ ……………………… ( )

Equation 4 above reveals that as a result of increase in income in any year from a previous
year – , increase in the investment will be times more than the increase in income. Hence, it
is i.e., capital-output ratio which represents the magnitude of the accelerator.

Thus, the simplest accelerator model predicts that investment is

proportional to the increase in output.

2.3.1.3. Tobin's Q Theory Of Investment

Many economists see a link b/n 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, because these profit
opportunities mean higher future income for the shareholders. Thus, stock prices reflect
the incentive 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:

 Numerator: the stock market value of the economy’s capital stock (i.e., it is the
number of shares outstanding times their market price).
 Denominator: the actual cost to replace the capital goods that were purchased
when the stock was issued.
Tobin reasoned that net investment should depend on whether q is greater or less
than one.
 If > 1, investors buy more capital to raise the market value of their firms.
 If < 1, the stock market values capital at less than its replacement cost and
thus, firms will not replace their capital stock as it wears out.

MACROECONOMICS- AMU 10
 CHAPTER SIX: THE THEORY OF INVESTMENT

As such, the q equation provides a correct indication of the current worth and likely
prospects for the business. If a firm faces a q>1, then this is a signal that it should
buy additional capital because the present value of the future earnings from such
capital will be greater than its cost.

6.3.1.4. The Keynesian Investment Explanation

In the simplest Keynesian model, aggregate investment in physical capital is a function

of the aggregate level of income and on the interest rate such that ( , ) where _
( ( , )) ( ( , ))
> and < . Thus, the Keynesians predict that investment should
r

increase with output. This prediction follows from an assumption of a long-run

relationship between the capital stock and . On the other hand, higher interest rates
means that it is more expensive for producers to take fund from financial institutions,
which should decrease investment.

In addition to the above, for Keynesians: “Investment is driven by perceptions of

future profitability”

Mr. J.M. Keynes emphasizes the role of expectations in the determination of

investment.
Keynes argued that in addition to the interest rate, profit expectations, and the
degree of confidence or weight that managers place in their profit forecasts,
determines investment .
For Keynes, investments are made until the present value of expected future
revenues-i.e., the expected return on investment; (marginal efficiency of capital in
Keynes terminology), is equal to the opportunity cost of capital (the discount rate
determined by central banks).
The computation of the expected return on investment (i.e., marginal efficiency of
capital) involves calculation of benefits and costs of the investment project under
consideration which basically depends on expectations (where expectations depend
on available information).
Keynes believed that the degree of confidence manager’s place in their forecasts will
also influence investment expenditures. If forecasts are deemed reliable by the

MACROECONOMICS AMU 11
 CHAPTER SIX: THE THEORY OF INVESTMENT

decision-maker, then they will be more inclined to base investment decisions on

their forecasts. The problem facing researchers has been how to measure this
subjective cognitive process. Lacking any direct measure of profit expectations,
researchers have been inherently unable to test Keynes' proposition that the profit
expectations and the weight assigned to profit expectations (i.e., the degree
of confidence decision-makers hold regarding their forecasts) are key determinants
of investment.
 In general, despite direct measure is lacking, since investment is founded on
expectations of future profitability for Keynes, business cycles are largely the
outcomes of fluctuations in these expectations.
6.3.2. RESIDENTIAL CONSTRUCTION INVESTMENT

Now, let’s consider the determinants of residential investment by looking at a simple

neoclassical model of the housing market. 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.

6.3.2.1. Neoclassical Model of Residential Investment

The neoclassical model of residential investment directly uses an important concept

when thinking about capital: the existing capital is a stock variable whereas investment
is a flow variable. This is true of any capital and investment but is made explicit in the
model we will learn about.
The idea is that there are two parts to housing:
 The market for the existing stock of houses which determines the equilibrium
housing prices, and
 The supply of new housing which determines the flow of residential investment.

A. The Stock Equilibrium and the Flow Supply

Note the following variables:

PH = the going price of housing in an economy
P = the price level in an economy
KH = stock of residential capital or housing, IH = investment in housing.
i. The Market for Existing Houses -Determining the Equilibrium Price
PH/P
 The relative price of housing, PH/P is determined jointly by demand & of supply for
housing.

MACROECONOMIC S, AMU 12
 CHAPTER SIX: THE THEORY OF INVESTMENT

 The stock of houses is fixed in the short-term, and so supply curve of existing houses
is vertical.
 The demand for housing is of the normal downward sloping form in the relative
price of housing.
ii. The Supply of New Housing -Determining Investment
We assume the law of supply that supplying extra quantities of new housing is more
expensive because of diminishing returns to the factors of production used by the firms.
That is, the existing resources become more expensive as firms bid up their prices to get
them, additional factors require higher payments to induce them to supply their
services, or the additional factors are just not as productive as existing resources used.
The Marginal benefit for firms or developers from building new housing is the relative
price of housing. To induce construction firms to build new houses the Marginal benefit,
or relative price, of building new housing has to be higher than the marginal cost. This
tells us that supply of new housing curve is upward sloping in the relative price of new
housing. Look the following figure.

Demand

Stock of housing capital, KH Flow of residential investment, IH

Fig: 6.3: The Housing Market

B. Changes in the Demand for and Supply of Housing
Any change in the relative price of housing just involves movements along the
existing curves, as per normal supply and demand curves.
Any other change involves a shift of a curve which will have other flow on effects.
For instance, a country’s population increases either because of an increase in
the reproduction rate or because of higher net immigration. This causes the
following sequence of things to happen:

MACROECONOMICS AMU 13
 CHAPTER SIX: THE THEORY OF INVESTMENT

i. Demand for housing curve shifts outwards

ii. PH/P increases to clear the housing market
iii. Supply of new housing increases, increasing the future stock of housing (this will
then cause a fall in PH/P although it will still be higher than the original level.

Stock of housing capital, KH Flow of residential investment, IH Fig:

Figure 6.4: Housing Investment
There are many other things that can affect the demand for housing
including: the interest rate (i.e. because it affects mortgage costs, or the opportunity
cost of holding wealth in housing); better technology, especially in building materials
and construction techniques (as it lowers the cost of supplying new houses and thus
shifts the supply curve down); incomes of people (i.e. how much income people have
affects their demand curves); and a host of other factors.
Summary of Residential Investment
i. An increase in the interest rate increases the cost of borrowing for home buyers and
reduces residential housing investment.
ii. An increase in population and tax policies shift the residential housing-investment
function.
iii. In a boom, higher income raises the demand for housing and increases residential
investment.

6.3.3. INVENTORY INVESTMENT

Inventory investment, the goods that businesses put aside in storage, is at the same time
negligible and of great significance. It is one of the smallest components of spending—
but its volatility makes it critical in the study of economic fluctuations.

6.3.3.1. Reasons for Holding Inventories

Before developing a theory of inventory investment let we see the reasons why
inventories are held. Knowing the reasons for holding inventories will help us

MACROECONOMICS- , AMU 14
 CHAPTER SIX: THE THEORY OF INVESTMENT

understand better the factors which influence the level of inventory investment. There
are four reasons for holding inventories:
i. Production Smoothing: Sales fluctuate, but many firms find it cheaper to produce
at a steady rate. That means,
When sales < production, inventories rise.
When sales > production, inventories fall.
ii. Inventories as a Factor of Production
 Firms carry inventories of spare parts in case a machine breaks down, so that
the entire assembly line does not come to a stop.
 Samples for retail sales purposes
iii. Stock-Out Avoidance
To avoid lost sales and profits when sales may be unexpectedly high e.g. a book retailer
may carry multiple copies of a book if they are not sure how popular the book will be.
iv. Work in Process: Partly completed products are counted as inventories (i.e., Goods
not yet completed are counted in inventory).
2.3.3.2. Accelerator Model of Inventory Investment

The accelerator model assumes that firms hold a stock of inventories that is
proportional to the firm’s level of output. Thus, if N is the economy’s stock of inventories
and Y is output, then =

where 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,
∆ .

Therefore, = ∆ = ∆

The accelerator model predicts that inventory investment is proportional to the change
in output.

 When output rises, firms want to hold a larger stock of inventory, so inventory
investment is high.
 When output falls, firms want to hold a smaller stock of inventory, so they allow
their inventory to run down, and inventory investment is negative.

MACROECONOMIC S, AMU 15
 CHAPTER SIX: THE THEORY OF INVESTMENT

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 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.

Summary of Inventory Investment

i. Higher interest rates increase the cost of holding inventories and decrease
inventory investment.
ii. According to the accelerator model, the change in output shifts the inventory
investment function.
iii. Higher output during a boom raises the stock of inventories firms wish to hold,
increasing inventory investment.

END OF THE CHAPTER!

Have U Achieved the Chapter Objectives?
(Go back & Read, then check whether u achieved the objectives defined at the
beginning of the chapter)- Do the ff questions to better refresh your understanding.

Review Exercises
1. In the Neoclassical model of business fixed investment, under what conditions will firms
find it profitable to add to their capital stock?
2. What is Tobin’s q, and what does it has to do with investment?
3. Explain why an increase in the interest rate reduces the amount of residential investment?
4. Use the Neoclassical model of investment to explain the impact of each of the following
events on the real rental price of capital, the cost of capital and investment:
A. Anti-inflationary monetary policy raises the real interest rate
B. An earthquake destroys some of the capital stock.
C. Immigration of foreign workers increases the size of the labor force.
5. Suppose that the firm faces a Cobb–Douglas production function with two inputs: K is
. .
capital, L is labor. The production function is given as: = .
 What happens to the real rental price of capital if?
A. Immigration raises the labor force by 10 percent.

MA, AMU 16
 CHAPTER SIX: THE THEORY OF INVESTMENT

B. A gift of capital/Machines from abroad raises the capital stock by 10 percent. (Use
graph)
C. Technological advancement raises the value of the parameter by percent.
6. Addis Ababa, the capital of Ethiopia experienced a large increase in population owing to
high birth rate and rural-urban migration in recent times. Use the Neoclassical model of
residential investment to predict the impact of this event on housing prices and residential
investment?
7. Our theories of investment suggest that investment depends on national income. That is,
higher income might induce firms to invest more. Explain why investment might depend
on national income?
8. Suppose that the firm faces a Cobb–Douglas production function with two inputs: K is
capital (the number of machines = ), L is labor (the number of workers = ). The
. .
production function is = . Suppose further the cost of capital to a Machine-
rental company. The company buys Machines for $ , each and rents them out to other
businesses, and the economy’s price level, $ . The company faces a real interest rate
of 10 percent per year and the machines depreciate at 20 percent per year.
A. Compute the marginal product of machines and the real cost of machines, and
interpret the result (should the rental firm add to its capital stock -invest in new
machines)?
B. What happen to the firms’ decision if the relative price of machines increases by 10%
and 15% in order?
C. What happen to the real rental price of capital/Machine if:
i. Immigration raises the labor force by 10 percent.
ii. An earthquake reduces the capital stock by 10 percent. (Support your explanation
using graph).
iii. Technological improvement raises the value of the parameter by 10 percent.
9. If a firm invests out of retained profits rather than borrowed funds, will its investment
decision still be affected by the changes in the real interest rate? Explain.
10. The theories of investment suggest that investment is related to the business cycle.
Explain why investment rises during expansion and falls during recessions by referring
to the theories?

MACROECONOMICS- AMU 17