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CHAPTER 15 Investment Spending Learning objectives Understand that investment is the most volatile sector 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. Power. Point® slides prepared by Marc Prud’Homme, University of of Ottawa Power. Point® slides prepared by Marc Prud’Homme, University Ottawa Copyright 2005 © Mc. Graw-Hill Ryerson Ltd.

Investment Spending o Investment spending is very volatile and thus responsible for much of 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. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 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: 2

Investment Spending Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Figure Investment Spending Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Figure 15 -1: Investment Spending and GDP, Annual Growth Rates, 1962 -2002 3

Investment Spending Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending o Investment Spending Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending o Business fixed investment: Annual investment increase in machinery, equipment, and structures used in production. o Residential investment: Investment in investment housing. o Inventory investment: Increase in the investment stock of goods on hand. o Flow of investment: The addition to the investment capital stock over some period of time. o Stock of capital: The value of all buildings, capital machinery, and inventories at a point in time. 4

BOX Why Investment is Volatile? 15 -1 o Private capital is roughly equal to 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. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 5

Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 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. 6

Stock Demand for Capital and the Flow of Investment o Income o Mortgage interest 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 Example 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. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 7

Stock Demand for Capital and the Flow of Investment 1) Investment is a principal 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: generally 2) Fiscal policy in the form of lower taxes on capital can directly increase investment. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 8

BOX Investment: Gross, Net, and More 15 -2 ü ü Gross Investment - depreciation BOX Investment: Gross, Net, and More 15 -2 ü ü 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 ü The rate of depreciation depends on the type of capital. ü This chapter ignores government investment. ü 15% - 20% of private capital stock. ü Individuals also invest in human capital. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 9

Stock Demand for Capital and the Flow of Investment 1) Rental (user) cost of 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) Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending o The desired capital stock: Overview (1) 10

Stock Demand for Capital and the Flow of Investment Value of Marginal Product of 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 rc 1 A higher cost of capital… … brings a lower desired capital stock. rc 0 Chapter 15: Investment Spending Figure 15 -2: Marginal Product of Capital in Relation to the Capital Stock YY K*1 K*0 Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Capital stock K 11

Stock Demand for Capital and the Flow of Investment Value of Marginal Product of 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. rc 1 Chapter 15: Investment Spending Figure 15 -3: Shift in the Marginal Product Curve YY 1 YY 0 K*1 Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Capital stock K 12

Stock Demand for Capital and the Flow of Investment Chapter 15: Investment Spending o Stock Demand for Capital and the Flow of Investment Chapter 15: Investment Spending o Expected output: From equation 1), the output 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 Capital addition to taxes and depreciation, the rental cost of capital is affected by taxes. o Corporate income tax. o Investment tax credit. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 13

Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 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. 14

Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending o The Stock Market and the Cost of Capital: Firms Capital 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 Investment 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 Investment Figure 15 -4. 15

Stock Demand for Capital and the Flow of Investment Chapter 15: Investment Spending Figure Stock Demand for Capital and the Flow of Investment Chapter 15: Investment Spending Figure 15 -4: Demand for Capital Stock and Flow of Investment P 1 P 0 DD 1 DD 0 K 1 Capital stock Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. I 0 I 1 Investment Flow 16

BOX Demand for Capital: A Cobb-Douglas Example 15 -3 √ √ Y = AF(K, 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 N 1 - = A(K/N) -(1 - ) = Y/K √ Y/K = rc √ K* = g(rc, Y) = Y/rc Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 17

Stock Demand for Capital and the Flow of Investment K = K-1 + (K* Stock Demand for Capital and the Flow of Investment K = K-1 + (K* - K-1) I = K - K-1 = (K* - K-1) (2) (3) Chapter 15: Investment Spending o Capital Stock Adjustment o Flexible Accelerator Model: Asserts that firms Model 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. o Dynamic Behaviour: Behaviour that depends on Behaviour values of economic variables in periods other than the current period. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 18

Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Stock Demand for Capital and the Flow of Investment Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Figure 15 -5: Adjustment of the Capital Stock 19

Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending o Business Fixed Investment: Business fixed investment is Investment the largest of the Investment subsectors. o Residential Investment: Residential investment is low when Investment 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 Investment 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. 20

Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 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 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. 21

Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Figure 15 -6: Components of Investment as a Percentage of GDP, 1961 -2002 22

Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Figure 15 -7: Residential Investment and Mortgage Interest Rates, 1961 -2002 23

BOX Credit Rationing 15 -5 o Credit rationing: Important additional channel of transmission of 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. Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 24

BOX Monetary Policy and Residential Construction 15 -6 Copyright 2005 © Mc. Graw-Hill Ryerson BOX Monetary Policy and Residential Construction 15 -6 Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 25

Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Business Fixed, Residential, and Inventory Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Figure 15 -8: Change in GDP and the Level of Inventory Investment, 1962 -2002 26

Investment and Aggregate Supply Ratio of Investment to Output (%) Country 1975 1997 Canada 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 Chapter 15: Investment Spending Table 15 -3 15. 3 Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 27

Chapter Summary Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending • Chapter Summary Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 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 real interest rate, the lower the price of the firm’s stock, and the higher the depreciation rate of capital. 28

Chapter Summary (cont’d) Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. Chapter 15: Investment Spending Chapter Summary (cont’d) Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 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. 29

The End Chapter 15: Investment Spending Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 30 The End Chapter 15: Investment Spending Copyright 2005 © Mc. Graw-Hill Ryerson Ltd. 30