macroeconomics ii investment demand (spending) · pdf fileinvestment demand (spending)...

MACROECONOMICS II

INVESTMENT DEMAND

(SPENDING)

1 Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe

INVESTMENT DEMAND (SPENDING)

In macroeconomics, Investment Demand is

important for two reasons:

1) Volatile and hence responsible for much fluctuations in GDP across the business cycle.

2) Because of its link with interest rates, it is a means by which fiscal and monetary policy affects the economy.

Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 2


• Investment spending links the present to the future, in that, it offers the possibility today of raising standards of living in the future.

• Consequently, the average level of Investment spending (by adding to the capital stock) plays a key role in long-run economic growth.



Three types of Investment demand can be

identified:

1) Business fixed investment (the K in the production function).

2) Residential investment (new housing).

3) Inventory investment (goods businesses put in storage, including materials and supplies, work-in-progress and finished goods)



• Typically, business fixed investment is

the largest component of investment

spending in an economy.

• Whilst inventory investment is

considerably smaller than the other two.

• Nevertheless, all three are volatile.



Before we begin, a note on terminology!

• Investment in macroeconomics is the

flow of spending that adds to the physical

stock of capital.

• Capital stock is the money value of all

buildings, machines, and inventories at a

point in time.



Thus, it is worth noting that the theories

that we discuss for all the three types of

investment spending emphasise two

elements:

1. The demand for capital, and

2. Investment as a flow which adds to the level of the capital stock.



Business Fixed Investment: The

Neoclassical Approach

• Here we go beyond the simple investment function, I = I (r), to examine the role of output, financial constraints and taxes in determining investment.

• We also look at how policy affects investment.



• The neoclassical model examines the

benefits and costs to firms of owning

capital goods.

• Two simply our analysis we assume two

firms, Production Firms and Rental

Firms.

• In reality, most firms act as both.



• Production firms produce goods and

services using capital they rent.

• Rental firms make all the investment in

the economy; they buy capital and rent it

out to production firms.



• The typical production firm rents out capital

in order to produce goods and services, and

weighs the benefits and costs associated with

this decision.

• The firm rents capital at R and sells goods at

a market price P.

• The real cost of production is defined as R/P.



• The real benefit of capital is the marginal

product of capital, MPK, which is the

increase in output produced by using 1

more unit of capital.

• We know from microeconomic theory,

that the MPK declines as more capital is

used in production.



• As a profit maximizing firm, it aims to equate the benefits to costs, or equate the marginal product of capital to the rental price of capital (cost of capital).

• As long as the value of the marginal product of capital is above the real rental price of capital, it pays the firm to add to its capital stock.



In the next slide we illustrate equilibrium in the market for rental capital.

• The marginal product of capital determines the demand curve; it slopes downwards because the MPK is low when the level of capital is high.

• At any point in time the supply of capital is fixed, so the supply is vertical



What influences the equilibrium real rental

price?

• We begin by considering a typical

production function:

• Y is output, A measures technology, K is

capital input, L is labour input.

• ; measures capital’s share of Y


1LAKY

10


• The MPK can defined as

• In equilibrium:


1

K

LAMPK

1

K

LA

PR


• The expression below identifies the

variables that determine the Real Rental

Price of Capital.


1

K

LA

PR


1) The lower the stock of capital, the higher the real rental price of capital.

2) The greater the amount of labour employed, the higher the real rental price of capital.

3) The better the technology, the higher the rental price of capital.



The Cost of Capital

• We now consider the case of Rental firms.

As with Production firms, we consider the

benefits and costs of owning capital.

• The benefits come from the revenues

earned by renting out capital, and thus

receives a rental price of R/P.



• In respect of the costs, we like to think of

the firm as financing the purchase of

capital by borrowing.

• However, for each period of time that the

Rental firm rents outs a unit of capital, it

bears three costs.



1. When the firm borrows to buy capital, it

must pay interest on the loan. If PK is the

purchase price, then iPK is the interest cost.

(note the interest cost will be the same even

if the firm doesn’t borrow).

2. Because the price of capital can change

while the firm rents out, there could be a

gain or loss ( ), here representing cost.


KP


3. While the capital is rented out, it

suffers depreciation. If is the rate of

depreciation, then the cost of

depreciation is .

• The total cost of renting out can

therefore be given by (see next slide)


KP



)(

KKK

KKK

PPiPC

PPiPC


• The cost of capital depends on the price

of capital, the interest rate, the rate at

which capital prices are changing, and

the depreciation rate.

• To make our lives even easier, we

assume that the prices of capital goods

rises with the prices of other goods.



• In that case, we can redefine the rate of

change in the price of capital as the

inflation rate, hence

• We also know that the real rate of

interest can be defined as


K

K

P

P

ir


In that case the cost of capital, C, can be

defined as:

This states that the cost of capital depends

on the price of capital, the real interest

rate and the rate of depreciation.


)( rPC K


We can also express the cost of capital

relative to other goods in the economy:

Real Cost of Capital =

This states that the real cost of capital depends

on the relative price of a capital good, the real

Interest rate and the rate of depreciation.


)(

rP

PK


The Determinants of Investment

Now we consider the situation in which the

rental firm decides whether to increase or

decrease the capital stock.

We know that for each unit of capital, the firm

earns real revenue and bears real cost. The real

profit per unit of capital is:



Profit Rate = Revenue – Cost

Profit Rate =

Because in equilibrium,

the profit rate can be stated as:


)(

r

P

P

P

R K

MPKPR


Profit Rate =

The Rental firm makes a profit if the

marginal product of capital is greater than

the cost of capital. It makes a loss if the

opposite holds.


)(

r

P

PMPK K


• Thus we see that whether a Rental firm adds to the capital stock or allows it to depreciate depends on whether owning and renting out capital is profitable.

• The change in capital stock is defined as net investment.

• The same conclusion applies to a firm that both uses and owns capital.



• In other words, whether a firm actually

buys its own capital or leases it, the

cost of capital (rental cost) is the right

measure of the opportunity cost.

• Remember, resources have alternative

uses!



• That is, for such a firm additions to the

capital stock depends on whether it is

profitable or not. In other words,

whether the marginal product of capital

exceeds the cost of capital.

• In the regard we can express the change

in the capital stock as:



Where (...) is the function showing how

net investment responds to the incentives to

invest.


)]([

rP

PMPKIK K

n

nI


We can now write an expression for the

investment function:

Total spending on business fixed investment is

the sum of net investment and the replacement

for depreciated capital.


KrP

PMPKII K

n

)]([


The model now shows how investment

Relates with the interest rate. A reduction in

real interest rate lowers the cost of capital.

This increases the profit from owning

capital and thus causes capital to increase.

By similar reasoning, a rise in the real interest rate

raises the cost of capital, reducing profitability and

hence causing a decline in capital.



For the reasons stated earlier, the investment

function/schedule, relating investment to the

interest rate slopes downwards.

The model also shows that any event that raises

the MPK (improvement in technology increases

the profitability of investment and causes the

investment schedule to shift outward.



Finally we consider what happens when the

capital stock is adjusting.

If the marginal product begins above the cost of

capital, the capital stock will rise and the marginal

product will fall.

If the marginal product of capital begins below the cost

of capital, the capital stock will fall and the Marginal

product will rise.



Eventually, as the capital stock adjusts, the

marginal product of capital approaches the cost

of capital. When the capital stock reaches a

steady-state level, we can write:


)(

rP

PMPK K


Thus, in the long run, the marginal product of

capital equals the real cost of capital.

The speed of adjustment toward the steady state

depends on how quickly firms adjust their

capital stock, which in turn depends on how

costly it is to build, deliver, and install new

capital.



Other Determinants of Investment

• An increase in the size of the economy

moves the entire MPK schedule to the right.

This rightward shift increases the demand

for capital at any given cost of capital (rental

cost).

• This may expressed in the form:


),(* YrcgK


Expected Output

But in the expression (reproduced below):

the level of output must be the level of output at

some future period, during which the capital will

be in production. For some investments the future time

at which output will produced is a matter of weeks or

months away, but for others this could be years away.


),(* YrcgK


• From this the notion of permanent

income is relevant to investment as well.

• The firm’s demand for business fixed

capital, which depends on the normal or

permanent level of output, thus depends

on expectations of future output levels,

rather than the current level of output.



Taxes

• In addition to interest rate and depreciation, the cost of capital is affected by taxes.

• The two main tax variables are the corporate tax and investment tax policy.

• A corporate tax is essentially a proportional tax on profit. An investment tax policy may allow firms to deduct from their taxes a fraction of their investment expenditures each year.



Taxes

• Corporate taxes generally tend to affect the desired stock of capital negatively, such that an increase in the corporate tax rate will adversely impact on investment spending by the firm.

• On the other hand the investment tax policy reduces the cost of capital, hence this has a positive impact on investment spending by firms.



The Effects of Fiscal and Monetary Policy

on the Desired Stock of Capital

• We have seen that the desired capital stock increases when the expected level of output rises and when the cost of capital falls.

• The cost of capital falls when the real interest rate and the rate of depreciation fall and when investment tax credits (investment tax policy) rises.

• An increases in the corporate tax reduces the desired capital stock.



The Effects of Fiscal and Monetary Policy

on the Desired Stock of Capital

• These conclusions imply that monetary and fiscal policy affect the desired capital stock.

• Fiscal policy exerts an effect through both the corporate tax and investment tax credit.

• Fiscal policy through its effect on the IS curve, which in turn affect interest rates can affect overall demand for capital.

• Monetary policy affects capital demand by affecting the market interest rate.


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