Investment - University of North Texaskim1/teaching/Macro_1/14_INVEST.pdf · Neoclassical Model of Investment For simplicity, assume two types of ﬁrms 1 Production ﬁrms:rent the

Investment

Intermediate Macroeconomic TheoryMacroeconomic Analysis

University of North Texas

ECON 3560 / 5040 Investment

Outline

Introduction

Investment is the most volatile component of GDP

Three Types of Investment

1 Business fixed investment: the equipment and structures thatbusiness buy to use in production

2 Residential investment: new housing that people buy to live inand that landlords buy to rent

3 Inventory investment: those goods that businesses put aside instorage, including materials and supplies, work in process, andfinished goods

Introduction

⇒ Investment are a key element of SR fluctuationsThree Types of Investment

Introduction

U.S. investment and its components

Billions of 1996 dollars

-250

0

250

500

750

1000

1250

1500

1750

2000

1970 1975 1980 1985 1990 1995 2000 2005

Total investment

Business fixed investment

Residential investment

Change in inventories

Outline

Business Fixed InvestmentNeoclassical Model of Investment

For simplicity, assume two types of firms

1 Production firms: rent the capital they use to produce goods andservices

2 Rental firms: own capital, rent it to production firms

In this context, “investment” is the rental firms’ spending on newcapital goods

Production firms’ decisions

⇒ Profit maximization: R/P = MPK

Rental firms’ investment decisions

⇒ Real profit: R/P− PKP (r + δ) or MPK −PKP (r + δ)

The change in capital (net investment) depends on thedifference between MPK and the cost of capital

⇒ I = f [MPK − PKP (r + δ)] + δK

1 Real cost of a unit of capital: R/P

2 Real benefit of a unit of capital: MPK

⇒ I = f [MPK − PKP (r + δ)] + δK

1 Real cost of a unit of capital: PKP (r + δ)

2 Real benefit of a unit of capital: R/P

⇒ I = f [MPK − PKP (r + δ)] + δK

1 MPK > cost of capital→ add to their capital stock2 MPK < cost of capital→ let their capital stock shrink⇒ I = f [MPK − PKP (r + δ)] + δK

⇒ I = f [MPK − PKP (r + δ)] + δK

Investment function: I = f [MPK − PKP (r + δ)] + δK

Implications

1 An increase in r

2 An increase in MPK

3 An increase in PK/P

Taxes and investment

Corporate income tax (CIT): if PK rises over time, CITdiscourages investment

Investment tax credit (ITC): effectively reduces PK whichincreases the incentive to invest

Implications

1 An increase in r

Implications

1 An increase in r

Implications

1 An increase in r

Implications

1 An increase in r

Implications

1 An increase in r

Implications

1 An increase in r

Implications

1 An increase in r

Business Fixed InvestmentThe Stock Market and Tobin’s q

Stock prices reflect the incentives to invest

Tobin’s q = market value of installed capitalreplace cost of installed capital

Net investment decision

q > 1→ firms buy more capital to raise the market value of theirfirms

q < 1→ firms do not replace capital as it wears out

⇒ Stock prices tend to be high when firms have manyopportunities for profitable investment, because these profitopportunities means higher future income for the shareholdersTobin’s q = market value of installed capitalreplace cost of installed capital

1 numerator: stock market value of the economy’s capital stock

2 denominator: actual cost to replace the capital goods that werepurchased when the stock was issued

Business Fixed InvestmentThe stock market and GDP

Reasons for a relationship between the stock market and GDP

1 A wave of pessimism about future profitability of capital

2 A fall in stock prices

↓ stock price⇒ ↓ q⇒ ↓ I ⇒ ↓ Y2 A fall in stock prices

1 A wave of pessimism about future profitability of capital2 A fall in stock prices

↓ household wealth⇒ ↓ Y

Reflect bad news about technological progress and long-runeconomic growth⇒ Y will be expanding more slowly than peoplehad expected

U.S stock market and GDP

Percent change

from1 year earlier

Percent change from1 year earlier

-30

-20

-10

0

10

20

30

40

50

1970 1975 1980 1985 1990 1995 2000 2005-6

-4

-2

0

2

4

6

8

10

Stock prices (left scale)

Real GDP (right scale)

Outline

Inventory Investment

Inventory investment is only about 1% of GDP

Yet, in the typical recession, more than half of the fall inspending is due to a fall in inventory investment

Motives for holding inventories

1 Production smoothing: when sales are low, the firm producesmore than it sells and put the extra goods into inventory

2 Inventories as a factor of production: inventories allow somefirms to operate more efficiently

3 Stock-out avoidance: avoid running out of goods when sales areunexpectedly high

4 Work in process: goods not yet completed are counted ininventory

Inventory InvestmentThe Accelerator Model

Assumption: firms hold a stock of inventories (N) that isproportional to the firm’s level of output

⇒ N = βY

Inventory investment: the change in the stock of inventories

⇒ ∆N = β∆Y

The opportunity cost of holding goods in inventory:

the interest that could have been earned on the revenue fromselling those goods

⇒ inventory investment depends negatively on the real interestrate

⇒ N = βY

⇒ ∆N = β∆Y

⇒ N = βY

⇒ ∆N = β∆Y

⇒ N = βY

⇒ ∆N = β∆Y

⇒ N = βY

⇒ ∆N = β∆YWhen output is rising, firms increase inventories

When output is falling, firms allow their inventories to run down

⇒ N = βY

⇒ ∆N = β∆Y

⇒ N = βY

⇒ ∆N = β∆Y

⇒ N = βY

⇒ ∆N = β∆Y

Evidence for the Accelerator Model

Inventory investment (billions of

1996 dollars)

Change in real GDP (billions of 1996 dollars)

-40

-20

0

20

40

60

80

100

-200 -100 0 100 200 300 400 500

19822001

2004

1998 1984

1978

1996

1983

1967

1974

IntroductionBusiness Fixed InvestmentResidential InvestmentInventory Investment

Documents

Investment - University of North Texaskim1/teaching/Macro_1/14_INVEST.pdf · Neoclassical Model of Investment For simplicity, assume two types of ﬁrms 1 Production ﬁrms:rent the