Transcript Chapter 13

Chapter 13
Investment Spending
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-1
Objectives
• Understand how investment depends on interest
rates and income
• Explain why fluctuations in investment are very
volatile
• Understand the theory of the demand for capital
• Identify patterns of investment in the different
sub sectors
• Link investment and aggregate supply
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-2
Investment Spending
• Investment links the present to the future.
– Investment determines the long-run rate at which an
economy adds to its stock of physical capital, which
helps determine long-run growth.
• Investment spending links the money market
to the goods market.
– It is the primary link through which interest rates and,
therefore, monetary policy, affect the economy.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-3
Investment Spending
• The theory of investment is the theory of the
demand for capital.
• Investment is the flow of spending that adds
to the physical stock of capital.
• Capital is a stock, the given dollar value of
all the buildings, machines and inventories
at a point in time.
• The flow of investment is quite small relative
to a nation’s stock of capital.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-4
Investment Spending
• The relationship between the stock of capital and
the flow of investment explains why investment is
such a volatile sector of AD.
• It also explains why investment has a relatively
small effect on AS in the short run.
• Over the long run the investment flow entirely
determines the capital stock.
• It is therefore one of the most important
determinants of AS in the long run.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-5
Chapter Organisation
13.1
The Stock Demand for Capital
and the Flow of Investment
13.2
Investment Subsectors: Business Fixed,
Residential and Inventory
13.3
Investment and Aggregate Supply
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-6
13.1 Stock Demand for Capital and the
Flow of Investment
• Businesses and consumers demand a stock
of capital in the form of machines and homes.
• The supply of capital is a fixed stock at a point
in time.
• When demand is greater than supply there is a
flow of investment in the form of new machines,
new factories and home construction.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-7
The Desired Capital Stock: Overview
• Firms are assumed to take a profit-maximising
approach in investment decisions.
• They equate the extra product of capital with
the user or rental cost.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-8
The Desired Capital Stock: Overview
• The marginal product of capital (MPK) is the
increase in output produced by using one extra
unit of capital in production.
• The cost of capital is more difficult to measure.
• While there are markets for capital, there
are much less developed markets for
capital services.
• We therefore consider firms renting the capital
from themselves.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-9
The Desired Capital Stock: Overview
• The rental cost of capital is defined as the
(opportunity) cost of using one more unit of
capital in production.
• Deriving the rental cost of capital
o Firms finance the purchase of capital by borrowing
or using retained earnings.
o Firms must take into account the impact of inflation
on investment decisions.
o The real cost of borrowing, or opportunity cost of
earnings, is the expected real interest rate r.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-10
The Desired Capital Stock: Overview
o r is the nominal interest rate i net of expected inflation e :
r = i – e
o Since capital wears out, depreciation (assumed to be
d per cent per year) must be included.
• The rental cost of capital (rc) is therefore:
o rc = r + d
o = i – e + d
o The rental cost of capital is an important method for
valuing a firm’s capital stock.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-11
The Desired Capital Stock: Overview
– If the value of the marginal product of capital is greater
than the rental cost, the firm adds to its capital stock.
– Thus, firms invest until the MPK is equal to the rental cost
of capital.
– Diminishing MPK means that the marginal product of
capital falls as capital increases.
– Figure 13.2 shows a MPK schedule.
– An increase in rc decreases the desired capital stock
(shown as a movement up along the schedule).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-12
The Desired Capital Stock: Overview
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-13
The Desired Capital Stock: Overview
• An increase in the MPK moves the schedule
rightwards which increases the demand for capital.
• The relationship between desired capital stock, K*,
the rental cost of capital rc, and the level of output
Y, is:
K* = g(rc, Y)
(13.1)
• An increase in rc decreases K* and an increase in
Y increases K*.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-14
The Effects of Fiscal and Monetary Policy
on the Desired Capital Stock
• Fiscal policy shifts the IS curve which affects
interest rates and output and thus the demand
for capital.
• Fiscal policy also affects capital demand through
corporate tax levels and investment tax credits.
• Monetary policy shifts the LM curve which affects
interest rates and thus the demand for capital.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-15
The Share Market and Cost of Capital
• A firm may also finance investment by selling
shares or equity.
• When the share price is high, a company can
raise more with less dilution of ownership.
• When share prices are low the firm must sell
more shares to raise required funds.
• Corporations are more willing to sell equities
when the share market is high rather than low.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-16
The q Theory of Investment
• Tobin’s q is the marginal (share market) valuation
of a firm’s new assets, relative to the cost of
producing those assets.
• In its simplest form, q is the ratio of the market
value of a firm to the replacement cost of capital.
• When q > 1, a firm should add capital because
for each dollar’s worth of new machinery the firm
can sell shares for q dollars and gain q – 1 profit.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-17
From Desired Capital Stock to Investment
• Capital stock adjustment—the flexible accelerator
model
– Explains the speed which firms plan to adjust their
K stock towards the desired level K* over time.
– Claims that the larger the gap between the existing
K and K* stock, the higher is a firm’s rate of investment.
– Firms plan to close a fraction,  of the gap between
desired and actual stocks each year.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-18
From Desired Capital Stock to Investment
– Hence, net investment I is given by:
I = K – K-1 =  (K* – K-1)
(13.2)
– The larger the , the faster the gap is reduced
– Equation 13.2 tells us that current investment spending
is determined by the desired stock of capital K* and the
actual stock K.
– Hence, increases in expected output, decreases in
real interest rates or increases in investment tax
credit increases K* and thus the rate of investment, I.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-19
Chapter Organisation
13.1
The Stock Demand for Capital
and the Flow of Investment
13.2
Investment Subsectors: Business Fixed,
Residential and Inventory
13.3
Investment and Aggregate Supply
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-20
13.2 Investment Subsectors
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-21
Investment Subsectors
– Figure 13.6 demonstrates the volatility of each of
the three investment subsectors: business fixed,
residential and inventory investment.
• Business fixed investment
– Firms use outside funding from banks, bond markets
and equity as sources of funding.
– As well, they rely on retained earnings to finance
investment.
– Retained earnings are especially important for
smaller firms.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-22
Business Fixed Investment
• Credit rationing may impact on the extent to
which investment changes.
• Credit rationing occurs when the firm borrow
even though it is willing to pay the prevailing
interest rate.
• In such circumstances investment decisions
are effected by retained earnings as well as
interest rates.
• The rate of investment is determined by profits,
interest rates and the volume of retained earnings.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-23
Residential Investment
• Residential investment consists of dwellings.
• It is low when mortgage interest rates are high
and declines during recessions.
• The demand for housing stock depends on the
net real return obtained by owning a house.
– The gross return consists of rent or the implicit return
by living in the home plus capital gains.
– The costs consist of interest costs plus any real estate
taxes and depreciation.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-24
Monetary Policy and Housing Investment
• Monetary policy has powerful effects on housing
investment.
• The demand for housing is sensitive to both
the real and nominal interest rates.
• The high levels of debt by homeowners means
the RBA does not have to increase interest
rates by much to reduce activity.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-25
Monetary Policy and Housing Investment
• Home owners make full nominal payments up front
and receive offsetting capital gains in the future.
• Banks use rules of thumb to qualify mortgage
applicants (e.g. repayments can be no more than
30% of income).
• Both these liquidity effects depend on nominal
(not real) interest rates.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-26
Inventory Investment
• Inventories consist of raw materials, goods in
the process of production, and completed goods
held by firms.
• Firms hold inventories for several reasons:
– To meet future demand for goods
– To smooth production, reduce shortages of inputs
– It is less costly for firms to order goods less frequently
in large quantities.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-27
Anticipated vs Unanticipated Inventory
Investment
• If sales were unexpectedly low, firms would
find inventories accumulating (unanticipated
and undesired investment in inventories).
• Firms may plan to build up inventories
(anticipated or desired investment).
• Unanticipated inventory investment is a
result of unexpectedly low AD.
• Planned inventory investment adds to AD.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-28
Inventories in the Business Cycle
• Inventory investment fluctuates proportionately
more over the business cycle than any other
component of AD.
• Prior to a recession, firms anticipating continuing
sales increase inventories (intended inventory
accumulation).
• With slower and then negative growth, output
initially stays high relative to sales (unintended
inventory accumulation).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-29
Chapter Organisation
13.1
The Stock Demand for Capital
and the Flow of Investment
13.2
Investment Subsectors: Business Fixed,
Residential and Inventory
13.3
Investment and Aggregate Supply
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-30
13.3 Investment and Aggregate Supply
• Investment is an important component of AD.
• Is it an important determinant of AS?
– In the short run: No.
– In the long run: Yes.
• Increasing investment in the long run increases
the capital stock, which increases an economy’s
capacity for higher growth.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-31
Investment and the Government
• Traditionally, the government supplies much of
the economy’s basic infrastructure (public goods).
• Examples include infrastructure for transport,
education and communications plus a stable
legal system.
• Provision of quality public infrastructure
encourages private business investment.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-32
Investment and the Government
• Government spending on infrastructure may
‘crowd out’ private investment.
• Public investment expenditure in Australia
has fallen from around 7% of GDP in the
1960s and 1970s to around 4% of GDP today.
• This could be of concern if a positive
relationship between private and public
investment is assumed.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-33
Investment and the Government
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
13-34