Transcript Présentation PowerPoint - McGraw Hill Higher Education

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CHAPTER
15
Investment Spending
Learning objectives




Understand that investment is the most volatile sector of
aggregate demand.
Understand that the demand for capital depends on
interest rates, output, and taxes.
Understand that investment reflects the adjustment of the
existing capital stock to the current demand for capital.
Understand that investment spending is the primary link
from monetary policy to aggregate demand.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Investment Spending
o Investment spending is very volatile and thus
responsible for much of the fluctuations in GDP across
the business cycle.
o Investment spending is a primary link through which
interest rates, and therefore monetary policy, affect the
economy. Tax policies affecting investment are
important tools of fiscal policy.
o On the supply side, investment over long periods
determines the size of the stock of capital and thus
helps determine long run growth.
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Chapter 15: Investment Spending
o Investment links the money markets to goods
market. Investment fluctuations drive much of the
business cycle.
o Interesting features of the investment cycle are:
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Investment Spending
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Chapter 15: Investment Spending
Figure 15-1: Investment Spending and GDP, Annual Growth Rates, 1962-2002
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Investment Spending
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Chapter 15: Investment Spending
o Business fixed investment: Annual
increase in machinery, equipment, and
structures used in production.
o Residential investment: Investment in
housing.
o Inventory investment: Increase in the
stock of goods on hand.
o Flow of investment: The addition to the
capital stock over some period of time.
o Stock of capital: The value of all buildings,
machinery, and inventories at a point in
time.
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BOX
Why Investment is Volatile?
15-1
o Private capital is roughly equal to 2.5
years’ GDP.
o Investment is equal to about one-sixth of
GDP.
o The stock of capital is approximately 15
years’ worth of investment.
o A 1 percent drop in the capital stock is
produced by a 15 percent change in
annual investment flow.
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Stock Demand for Capital and the Flow of Investment
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Chapter 15: Investment Spending
o Businesses and consumers demand a
stock of capital in the form of machines
and houses.
o The supply of capital is a fixed stock at a
point in time.
o When the demand exceeds the supply, a
flow of investment in the form of new
machines and new house construction
starts to fill the gap.
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Stock Demand for Capital and the Flow of Investment
o Income
o Mortgage interest rates
o Taxes
o A drop in mortgage interest rates
Chapter 15: Investment Spending
o Example: The market for new homes where the
stock of new homes is greater then the number of
new homes built in a year.
o The demand for new homes depends on
o The monthly cost of home ownership drops and the
demand for housing rises.
o The price of existing homes increases.
o The flow of new housing investment rises.
o Housing prices and new housing investment drop back
to original levels.
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Stock Demand for Capital and the Flow of Investment
1)Investment is a principal conduit of
monetary policy into the goods market.
a) Interest rates are a prime determinant of the
cost of owning capital.
b)Loose monetary policy lowers interest
rates, lessens the cost of owning capital,
and increases the demand for capital.
Chapter 15: Investment Spending
o Two results from the analysis that
apply to investment more generally:
2)Fiscal policy in the form of lower taxes
on capital can directly increase
investment.
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BOX
Investment: Gross, Net, and More
15-2
 Gross Investment - depreciation = net investment.
 Aggregate supply depends on net investment
 Aggregate demand depends on gross
investment.
 Economic depreciation can be more rapid than
physical depreciation.
 The rate of depreciation depends on the type of
capital.
 This chapter ignores government investment.
 15% - 20% of private capital stock.
 Individuals also invest in human capital.
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Stock Demand for Capital and the Flow of Investment
1) Rental (user) cost of capital: The cost of using one more
unit of capital in production.
2) As long as the value of marginal product of capital is
above the rental cost, it pays the firm to add to its
capital stock.
3) Rental cost of capital:
rc = r + d = i - e +d (No taxes)
K* = g(rc, Y)
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Chapter 15: Investment Spending
o The desired capital stock: Overview
(1)
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Stock Demand for Capital and the Flow of Investment
Value of Marginal Product of Capital
Given the marginal
product of capital
in relation to the
capital stock
rc1
A higher cost of
capital…
… brings a lower
desired capital
stock.
rc0
Chapter 15: Investment Spending
Figure 15-2: Marginal Product of Capital in Relation to the Capital Stock
YY
K*1 K*0
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Capital stock
K
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Stock Demand for Capital and the Flow of Investment
Value of Marginal Product of Capital
An increase in the
size of the
economy shifts the
marginal product
curve to the right,
increasing the
desired capital
stock at any given
rental cost.
rc1
Chapter 15: Investment Spending
Figure 15-3: Shift in the Marginal Product Curve
YY1
YY0
K*0
K*1
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Capital stock
K
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Stock Demand for Capital and the Flow of Investment
Chapter 15: Investment Spending
o Expected output: From equation 1), the
demand for 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.
o Taxes and the Rental Cost of Capital: In
addition to taxes and depreciation, the
rental cost of capital is affected by taxes.
o Corporate income tax.
o Investment tax credit.
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Stock Demand for Capital and the Flow of Investment
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Chapter 15: Investment Spending
o The effects of fiscal and monetary policy on the desired
capital stock: From equation 1), the desired capital stock
increases when the expected level of output rises and when
the rental cost of capital falls. The rental cost of capital falls
when the real interest rate and the rate of depreciation fall
and when the investment tax credit rises. A higher
corporate tax rate is likely to reduce the desired capital
stock. Effects of economic policy:
o Fiscal policy exerts an effect through both the corporate
tax rate, the investment tax credit, and affects capital
demand by its overall effects on the position of the IS
curve and thus on the interest rate.
o Monetary policy affects capital demand by affecting the
market interest rate. A lowering of the nominal interest
rate by the Bank of Canada induces firms to desire more
capital.
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Stock Demand for Capital and the Flow of Investment
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Chapter 15: Investment Spending
o The Stock Market and the Cost of Capital: Firms
can also raise financing needs by issuing shares
or equity. Shareholders expect to earn a return
from dividends or from capital gains. Firms will
sell more equity to finance investment when the
stock market is high.
o The q Theory of Investment: Investment theory
emphasizing that investment will be high when
assets are valuable relative to their reproduction
cost. The ratio of asset value to cost is called q.
o From Desired Capital Stock to Investment: See
Figure 15-4.
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Stock Demand for Capital and the Flow of Investment
Chapter 15: Investment Spending
Figure 15-4: Demand for Capital Stock and Flow of Investment
P1
P0
DD1
DD0
K0
K1
Capital stock
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I0
I1
Investment Flow
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BOX
Demand for Capital: A Cobb-Douglas Example
15-3
√
√
√
√
Y = AF(K,N)
Y=AK N 1-
In Canada:  = 0.30
MPK = AK - 1 N1 -  = A(K/N) -(1 - ) =
Y/K
√ Y/K = rc
√ K* = g(rc, Y) = Y/rc
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Stock Demand for Capital and the Flow of Investment
K = K-1 + (K* - K-1)
I = K - K-1 = (K* - K-1)
Chapter 15: Investment Spending
o Capital Stock Adjustment
o Flexible Accelerator Model: Asserts that firms
plan their investment to close a fraction of the
gap between their actual capital stock and their
desired capital stock; a result is that more firms
with a larger gap between their actual and desired
capital stocks accumulate capital more quickly
than other firms.
(2)
(3)
o Dynamic Behaviour: Behaviour that depends on
values of economic variables in periods other
than the current period.
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Stock Demand for Capital and the Flow of Investment
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Chapter 15: Investment Spending
Figure 15-5: Adjustment of the Capital Stock
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Business Fixed, Residential, and Inventory
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Chapter 15: Investment Spending
o Business Fixed Investment: Business fixed investment is
the largest of the Investment subsectors.
o Residential Investment: Residential investment is low when
mortgage interest rates are high and it declines during
recessions.
o Demand for housing is sensitive to interest rates:
o If i = 5%, mthly pmt = $584; If i = 20%, mthly pmt = $1816
o Inventory Investment: Raw materials, goods in the process
of production, and completed goods held for eventual sale.
o To meet future demand.
o Reduce costs associated with ordering large quantities.
o Smooth production.
o Unavoidable part of production activities.
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Business Fixed, Residential, and Inventory
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Chapter 15: Investment Spending
o Inventory Investment
o Accelerator model: Asserts that investment spending is
proportional to the change in output and is not affected
by the cost of capital.
o Anticipated vs. Unanticipated Inventory Investment.
o Inventories in the Business Cycle.
o Inventory cycle: response of inventory to changes in
sales that causes further changes in aggregate
demand.
o Just-in-Time Inventory Management: Inventory
management strategy; firms hold inventories for as
short a time as possible by sending goods out as soon
as they are produced, and ordering parts only as they
are needed.
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Business Fixed, Residential, and Inventory
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Chapter 15: Investment Spending
Figure 15-6: Components of Investment as a Percentage of GDP, 1961-2002
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Business Fixed, Residential, and Inventory
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Chapter 15: Investment Spending
Figure 15-7: Residential Investment and Mortgage Interest Rates, 1961-2002
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BOX
Credit Rationing
15-5
o Credit rationing: Important additional
channel of transmission of monetary
Policy
o Occurs for two reasons:
1. Uncertainty of loan repayment.
2. Credit limits imposed on banks by the
central bank.
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BOX
Monetary Policy and Residential Construction
15-6
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Business Fixed, Residential, and Inventory
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Chapter 15: Investment Spending
Figure 15-8: Change in GDP and the Level of Inventory Investment, 1962-2002
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Investment and Aggregate Supply
Ratio of Investment to Output (%)
Country
1975
1997
Canada
25.2
19.3
United States
16.8
17.9
Japan
32.8
28.5
Korea
27.1
35.0
Singapore
37.6
35.1
Bangladesh
5.5
15.3
Ethiopia
5.5
15.3
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Chapter 15: Investment Spending
Table 15-3
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Chapter Summary
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Chapter 15: Investment Spending
• Investment is spending that adds to the capital
stock.
• 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 real interest rate is the nominal interest
rate minus the inflation rate.
• 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.
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Chapter Summary (cont’d)
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Chapter 15: Investment Spending
• In practice, firms decide how much to invest
using discounted cash flow analysis.
• The accelerator model of investment is a
special case of the gradual adjustment model
of investment.
• Because credit is rationed, firms’ investment
decisions are affected also by the state of their
balance sheets, and thus by the amount of
earnings that they have retained.
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The End
Chapter 15: Investment Spending
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