Macalester College Intermediate Macroeconomic Analysis

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Macalester CollegeIntermediate Macroeconomic
Analysis

• INVESTMENT

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Three Types of Investment

• Business fixed investment Business spending on
  equipment and structures for use in production
• Residential investment Purchases of new housing
  units (either by occupants or landlords)
• Inventory investment The value of the change in
  inventories of finished goods, materials and
  supplies, and work in progress.

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slide 3
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Why do we care about investment spending?
Kt Kt-1 It - ?Kt-1
or
?Kt Kt - Kt-1 It - ?Kt-1
Net Investment Gross Investment - Depreciation
The flow of investment spending determines how
rapidly the capital stock evolves
The capital stock determines the productive
capacity of the economy.
Yt AtF(Lt, Kt)
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A Micro Model of Investment
Two firms

• A law firm rents office space and sells legal
  services.
• A property company builds office space and rents
  it to law firm.

Law firm profit maximization
MPKP R
(2 hours/sq. ft.)
(100/hour)
200/sq. ft.
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A Micro Model of Investment
Property company
R/P
R adjusts to clear the market
KS
height ? willingness to rent
2 hours
sq. ft.
KD
Legal firm
K
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An Increase in the Demand for Capital
?A ? ?MPK
MPKP R
R/P
(2 hours/sq. ft.)
(100/hour)
200/sq. ft.
KS
(3 hours/sq. ft.)
(100/hour)
300/sq. ft.
3 hours
sq. ft.
2 hours
As capital becomes more productive, the demand
for it rises as well as its rent (price)
sq. ft.
1KD
0KD
K
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Factors that affect the rental price

• For the Cobb-Douglas production function,

the MPK (and hence equilibrium R/P ) is

• The equilibrium R/P would increase if
• ?K (due, e.g., to earthquake or war)
• ?L (due, e.g., to pop. growth or immigration)
• ?A (technological improvement, or deregulation)

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Should the Property Company Invest?
How much does an additional unit of capital cost?
i nominal interest rate
PK price of capital (cost of constructing new
building)
? depreciation rate
Cost of Capital (iPK - ?PK ??PK)
Capital Gain/Loss
Interest cost
Depreciation cost
Cost of Capital (i - ?PK/PK ?)PK
If capital goods price inflation overall
inflation, ?, then
Cost of Capital (r ?)PK
Where r i - ?
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Criterion for Investment
Property Companies Profit Rate Revenue - Cost
R - (r ?)PK
Investment Criteria
R (r ?)PK
? current K optimal
? I ?K
R gt (r ?)PK
? increase K
? I gt ?K
R lt (r ?)PK
? reduce K
? I lt ?K
PK 800/sq. ft.
Suppose
r .10
? .15
No net invest
200/sq. ft. - .25x(800/sq. ft.)
0
Profit Rate
If A rises?
Profit Rate
300/sq. ft. - .25x(800/sq. ft.)
gt 0
? I gt ?K
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Dynamics
Loanable Funds Market
Office Space Market
r
R/P
K0
K1
K2
S
r1
(R/P)1
r2
(R/P)2
r0
I1
(R/P)0
MPK1
I2
I0
MPK0
S,I
K
20
30
100
110
115
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(Flow)
(Stock)
?K
Is the stock of office space changing?
No -- I ?K
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How should 9/11 Affect Investment Spending?
Office Space Market
Loanable Funds Market
R/P
r
K1
K0
S
r1
(R/P)1
r0
(R/P)0
I1
MPK0
I0
K
S,I
S0I0
S1I1
(Stock)
(Flow)
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Government Investment
Y AK?P?L1-?-?
Where P is public capital (e.g., roads, bridges,
airports)
?Y/?K MPK ?AP?L1-?/K1-?
?P ? ?MPK
What happens to the rent owners of private
capital earn (R), the interest rate (r), the flow
of investment spending (I), and the private
capital stock (K)?
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Tobins q

• numerator the stock market value of the
  economys capital stock
• denominator the actual cost to replace the
  capital goods that were purchased when the stock
  was issued
• If q gt 1, firms buy more capital to raise the
  market value of their firms
• If q lt 1, firms do not replace capital as it
  wears out.

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Tobins q and the Neoclassical Model

• The stock market value of capital depends on the
  current expected future profits of capital.
• If MPK gt cost of capital, then profit rate is
  high, which drives up the stock market value of
  the firms, which implies a high value of q.
• If MPK lt cost of capital, then firms are
  incurring loses, so their stock market value
  falls, and q is low.

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The Stock Market and GDP

• 1. A wave of pessimism about future profitability
  of capital would
• cause stock prices to fall
• cause Tobins q to fall
• shift the investment function down
• 2. A fall in stock prices would
• reduce household wealth
• shift the consumption function down
• A fall in stock prices might reflect bad news
  about technological progress and long-run
  economic growth.
• This implies that aggregate supply and
  full-employment output will be expanding more
  slowly than people had expected.

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The stock market and GDP, 1965-2003
slide 17
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Residential Investment
(a) The market for housing
(b) The supply of new housing
Supply
Supply
KH
IH
Stock of housing capital
Flow of residential investment
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Residential Investment and Interest Rates
(a) The market for housing
(b) The supply of new housing
Supply
Supply
KH
IH
Stock of housing capital
Flow of residential investment
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Inventories and the Real Interest Rate

• Inventory investment is only about 1 of GDP
• Yet, in the typical recession, more than half of
  the fall in spending is due to a fall in
  inventory investment.
• The opportunity cost of holding goods in
  inventory the interest that could have been
  earned on the revenue from selling those goods.
• Hence, inventory investment depends on the real
  interest rate.

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Determinants of Investment

• All types of investment depend negatively on the
  real interest rate.
• Factors that shift the investment function
• Technological improvements
• Increase in population
• Changes in the stock of capital
• Economic policies
• Investment is the most volatile component of GDP
  over the business cycle.
• Employment affects the MPK (business fixed
  investment).
• Income affects demand for housing (residential
  investment).
• Output affects planned unplanned inventory
  investment.