Chapter 12 Investment Spending

Fixed investment: the neoclassical approach Fixed investment is the most volatile component of

GDP.

Fixed investment: the neoclassical approach The desired capital stock: K*=g(rc, Ye)

Fixed investment: the neoclassical approach The rental cost and real interest rate:

rc=r+d;r=i-e;rc=i-e+d.

Taxes and the rental cost of capital:Corporate tax does not affect the trade-offs betwee

n MPK and rental cost;The problem:

,max[ ( , ) ](1 )K L

F K L wL rcK

Fixed investment: the neoclassical approach The stock market and the cost of capital

Investment financed by undistributed profits;Tobin’s average q: Q=V/PK;Firms invest until the marginal value of capital equ

als marginal replacement cost;The investment function: I/K=h(Q)

h(1)=0, h>0.

Booming stock market stimulates investment;Corporate income tax lowers Q and discourages in

vestment.

Fixed investment: the neoclassical approach The effects of fiscal and monetary policy on th

e desired capital stock:Increase in the expected Y: I increases;Decrease in rc: I increases;

Decrease in r, d, or increase in ITC.

Decrease in corporate profit tax t: I increases;Fiscal policy: t, ITC, r (through IS curve);Monetary policy: r and Q.

Fixed investment: the neoclassical approach Capital stock

adjustment: The old view: firms

adjust to desired level of capital instantly;

Modern theory: extra investment costs, investment are made gradually.

I=(K*-K-1)

Fixed investment: the neoclassical approach The timing of investment and investment tax

credit:Announced ITC in the future: delay investment

until ITC implemented;Temporary ITC: Squeeze investment into the

period when ITC is effective;Temporary shifts in the tax scheme may have a

stronger effect on investment.

Business fixed investment: alternative approaches Present value of marginal investment:

Cost of marginal investment: c; Carry out the investment if v>c; Implication: higher interest rate lowers current

value and discourages investment; Conceptually similar to previous theory.

1 1

1

1

t

tt s s

v Rr

Business fixed investment: alternative approaches The accelerator model:

K=kY;I=K=kY;Investment is proportional to output growth.