Macro Economics

Module 6
Class note 19
INVESTMENT
Dr. RK. Pattnaik
Professor,
Gokhale Institute of Politics and Economics, Pune.
Structure
• Introducing Investment Function
• Types of Investment spending
• Neoclassical theory of Investment and Tobin’s q ratio
Introduction
• Investment spending plays a key role not only in long-run growth but also in the
short-run business cycle because it is the most volatile component of GDP.
• When expenditure on goods and services falls during a recession, much of the
decline is usually due to a drop in investment.
• The study of investment function gives a better understanding of fluctuations in
the economy’s output of goods and services. The IS–LM model is 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.
• Now we look more closely to the theory behind this investment function
analysing the Neoclassical theory of Investment, Tobin’s q and Accelerator
theory of Investment
Types
• There are three basic components of investment spending viz. Business
fixed investment, Inventory investment and Residential investment.
• Business fixed investment, which includes spending by businesses on
equipment (computers, trucks, and machines) and structures (factories,
shopping centres, and hospitals) that are used in production.
• Inventory investment, which includes spending by businesses on
additional holdings of raw materials and parts used in production, as
well as finished goods.
• Residential investment, which includes spending on new housing,
whether it is occupied by owners or rented out by landlords.
Neoclassical theory of Investment or
Business Fixed Investment
• The term “business” means that these investment goods are bought by firms for use
in future production. The term “fixed” means that this spending is for capital that will
stay put for a while as, opposed to inventory investment, which will be used or sold
within a short time. Business fixed investment includes everything from office
furniture to factories, computers to company cars.
• The standard model of business fixed investment is called the neoclassical model of
investment. Dale Jorgensen of Harvard University develops the basic model for
describing the Neoclassical theory of investment in early 1960s.
• 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 marginal product of capital, the interest rate, and the tax rules
affecting firms.
• The Neoclassical model takes two kinds of firms production firm and rental firm.
Production firm and Rental firm
• Production firms produce goods and services using capital that they rent.
• Rental firms make all the investment in the economy. They buy capital and rent it out to production
firms.
• In real world most firms perform both functions.
• The neoclassical theory of investment states that the investment decisions are affected by the
following
• ■ expected future output (which is affected by future productivity and the business cycle)
• ■ the real price of capital
• ■ the real interest rate
• ■ the expected rate of change of the real price of capital
• ■ the depreciation rate
• ■ the tax rate on businesses
■ financing constraints (which reflect financial frictions)
Rental cost of Capital
• One important question is what is the desired level of capital stock for a given
rental cost of capital?
• The rental cost of capital is ratio of rental rate( R ) and the sale price(P) or this
is R/P.
• A firm will keep acquiring capital till the marginal product of capital equals
real rental cost of capital(MPK = R/P = rc) where rc is rental cost of capital.
• MPK is the increase in output produced by using one more unit of capital in
production.
• The Rental cost of capital is the cost of capital using one more unit of capital in
production.
• The real rental cost of capital is in terms of goods and services.
MPK = R/P = rc
• If MPK exceeds rc, the benefits of adding an extra unit of capital
outweigh its costs, and profit rises. Firms keep adding capital, but as
they do, the marginal product of capital begins to fall, a result of
diminishing returns.
• Eventually, the marginal product of capital declines to the level of the
real rental cost of capital, and MPK = rc. Similarly, if firms have too much
capital, then the real rental cost of capital will exceed the marginal
product of capital.
• As firms realize that they are losing money from holding too much
capital, they will keep cutting the amount of capital until the marginal
product of capital, MPK, rises to the real rental cost of capital, rc.
Rental cost of Capital(continue)
• In equilibrium R/P equals the marginal product of capital and for the
Cobb-Douglas production function this can be written as
R/P = aA(L/K) 1− a.
■ The lower the stock of capital, the higher the real rental price of
capital.
■ The greater the amount of labour employed, the higher the real
rental price of capital.
■ The better the technology, the higher the real rental price of capital.
User Cost of Capital and Desired
level of capital
• User cost of capital denoted by uc is the expected real cost of using a unit
of capital over a particular period.
• Any owner of capital has to consider three possible cost of using that
capital. First component is real interest rate,r multiplied by real price of unit
of capital,pk (rpk).
• Second, owner of the capital must take into account the real price of the
unit capital can change if the real price of capital is expected to rise the
owner will anticipate a gain(f =∆pek). Because the gain is a negative cost of
capital the effect on the user cost is - ∆pek .
• Third, When capital is used it is subject to wear and tear, so that it loses a
fraction of its value, the depreciation rate δ, in each period. The real
depreciation cost for a unit of capital is the depreciation rate multiplied by
the real price of the unit of capital, or δpk.
User cost of capital(continue)
Determining the desired level of
capital
• The desired level of capital is the capital stock that equates MPK and
uc.
Major Conclusions
• The neoclassical theory of investment derives the desired level of
capital from the condition that the marginal product of capital equals
the user cost of capital.
• It shows that the expected future desired level of capital and
investment spending is positively related to expected future output,
the expected rate of change of the real price of capital, depreciation
allowances, and the investment tax credit.
• The expected future desired level of capital and investment spending
is negatively related to the real price of capital, the real interest rate,
and the depreciation rate
Neoclassical theory
• The neoclassical theory of business fixed investment sees the rate of
investment being determined by the speed with which firms adjust
their capital stocks toward the desired level. The desired capital stock
is bigger the larger the expected output the firm plans to produce and
the smaller the rental or user cost of capital.
• The rental cost of capital is higher the higher the real interest rate, the
lower the price of the firm’s stock, and the higher the depreciation
rate of capital. Taxes also affect the rental cost of capital, in particular
through the investment tax credit. The investment tax credit is, in
effect, a government subsidy for investment.
Inventory Investment
• Inventories consist of raw materials, goods in the process of production, and completed
goods held by firms in anticipation of the products’ sale.
• Firms hold inventories because of the following
 To meet future demand for goods as goods cannot be instantly manufactured
 It is less costly for firms to order goods
 Producers hold inventory as a way of smoothing their production
• Firms have a desired ratio of inventories to final sales that depends on economic variables.
The smaller the cost of ordering new goods and the greater the speed with which such
goods arrive, the smaller the inventory-sales ratio. The inventory-sales ratio may also
depend on the level of sales, with the ratio falling with sales because there is relatively less
uncertainty about sales as sales increase.
• There is a interest cost involved in inventory holding and inventory-sales ratio is expected to
fall with increase in the interest rate
Tobin’s q
• Nobel Laureate James Tobin of Yale University developed a model of investment closely
related to the neoclassical theory, but which instead focuses on asset prices as a driver
of investment spending.
• Tobin’s q is ratio of market value of installed capital and replacement cost of installed
capital.
• The market value of installed capital is the economy’s capital as determined by the stock
market and replacement cost of installed capital is the price of that capital if it were
purchased today.
• If Tobin’s q is greater than one then the stock market values installed capital are more
than its replacement cost. In this case the firms can raise the market value of their
stocks by buying more capital
• .Conversely if q is less than one the stock market values capital are less than its
replacement cost. In this case firms will not replace capital as it wears out.
Tobin’s q and Neoclassical
investment
• Tobin’s q says that a rise in stock prices leads to a rise in Tobin’s q and a rise in investment, while a decline
in stock prices leads to a decline in Tobin’s q and a fall in investment spending.
• At first the q theory of investment may appear very different from the neoclassical model developed
previously, but the two theories are closely related.
• With Tobin’s q theory, we can reach the same conclusions as with the neoclassical theory:
1. A higher expected future marginal product of capital leads to a higher q and therefore higher
investment.
2. A rise in the real interest rate or a rise in the effective tax rate, each of which increases the user cost
of capital, lowers q and therefore causes investment to fall.

3. A higher price of capital increases the replacement cost of capital, which leads to a higher
denominator, lowers q, and causes investment to fall.
• However, Tobin’s q theory adds to the neoclassical theory because it emphasizes that asset-price
fluctuations, especially those in stock prices, can have an important independent effect on investment
spending.
Residential Investment
• Residential housing is just another form of capital, and so residential investment can be explained
by the neoclassical theory of investment, in which investment is determined by the marginal
product of housing and the user cost of housing.
• When more housing is needed (because of population growth or children leaving their parents’
homes) or when households have higher expected income, the marginal product of houses rises,
causing the desired stock of houses to rise. Hence, a rise in household formation or expected
income leads to higher residential investment.
• When mortgage rates rise or when house prices are expected to fall and so have a lower rate of
expected appreciation, the user cost of capital rises, decreasing the desired stock of houses.
Hence, a rise in mortgage rates or lower expected appreciation of housing leads to lower
residential investment.
• Financing constraints play a similar role in the housing market as in business fixed investment.
When it is harder to get a mortgage, financing constraints are tighter, and so people will not be
able to buy as much housing as they would like. Tighter financing constraints lead to lower
residential investment.
Conclusion
• Housing investment is affected by monetary policy because housing demand is sensitive
to the mortgage interest rate (real and nominal). Credit availability also plays a role.
• Monetary policy and fiscal policy both affect investment, particularly business fixed
investment and housing investment. The effects take place through changes in real (and
nominal, in the case of housing) interest rates and through tax incentives for investment.
• There are substantial lags in the adjustment of investment spending to changes in output
and other determinants of investment. Such lags are likely to increase fluctuations in GDP.
• Inventory investment fluctuates proportionately more than any other class of investment.
Firms have a desired inventory-to-sales ratio. The ratio may get out of line if sales are
unexpectedly high or low, and then firms change their production levels to adjust
inventories. For instance, when aggregate demand falls at the beginning of a recession,
inventories build up. Then when firms cut back production, output falls even more than
did aggregate demand. This is the inventory cycle.