Investment Function

ECON 3A. MACROECONOMICS

Investment

 Investment plays two roles in macroeconomics:

 It
can have a major impact on AD (real output and
employment)

 Itleads to capital accumulation (it increases the

national potential output and promotes economic
growth in the long run)
Types of Investment

 Business fixed investment

 businesses’ 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
Non-i determinants of Investment

 Revenues (return)
 an investment should bring the firm additional revenue
 Costs
 interest rate influences the costs of the investment
 Consumer demand
 the bigger the increase in consumer demand, the more
investment will be needed
 Expectation
 business expectation about future state of economy
The Investment Demand Curve

Interest
rate i Higher Output

D1
D
Investment spending
The Investment Demand Curve

Interest
rate i Higher Taxes

D
D1
Investment spending
The Investment Demand Curve

Interest
rate i Pessimistic Expectation

D
D1
Investment spending
In Theory of Investment

 In the simple Keynesian model, investment is

independent of national income (autonomous
investment).

 The investment function will be a horizontal straight line.

The Investment Function

I In the short-run it is
reasonable to assume that
investment is independent
of national income.
I2
I2
I1
I1

0 Y
Consumption and Investment
Functions
 The spending curve shows the level of desired
expenditure by consumers (CA + MPC.Y) and businesses
(I) corresponding to each level of output
Consumption and Investment
Functions

C, I
C + I = CA + MPC . Y + I

C = CA + MPC . Y

0 Y
Consumption and Investment
Determine Output
 If the level of output is e. g. Y1 at this level of output the
C+I spending line is above 45˚line, so planned spending
is greater than planned output

 This means that consumers would be buying more goods

than the businesses were producing

 Thus spending disequilibrium leads to a change in output

Equilibrium National Income

C, I

C + I = CA + MPC . Y + I
E
Consumption and investment
determine output

45˚
0 Y1 YE Y2 Y
Saving and Investment Determine
Output
 Equilibrium occurs when desired saving of households
equals the desired investment of businesses

 When desired saving and desired investment are not

equal, output will tent to adjust up or down
Saving and Investment Determine
Output
S, I

S = f (Y)

E
I

0
Y1 YE Y2 Y

-
Saving and Investment Determine
Output
 At output level Y2 families are saving more than
businesses are willing to go on investing
 Firms will have too few customers and large inventories
of unsold goods than they want
 Then, businesses will cut back production and lay off
workers
 This moves output gradually downward and economy
returns to equilibrium YE.
Investment Multiplier

 The Keynesian investment multiplier model shows that an

increase in investment will increase output by a
multiplied amount – by an amount greater than itself.

 The multiplier is the number by which the change in

investment must be multiplied in order to determine the
resulting change in total output.
Investment Multiplier

C, I C + I2
E2 I2 = I1 + ΔI
C +I1
ΔY = k . ΔI
E1

ΔI Δ𝑌
𝑘=
Δ𝐼

45˚
0 Y1 ΔY Y2 Y
Investment Multiplier

S = f (Y)

E2
I2
ΔI E1
I1

0
Y
Y1 ΔY Y2
-
Investment Multiplier

 The size of the multiplier k depends upon how large the MPC is.

Δ𝑌 Δ𝑌 1 1 1
𝑘= = = = =
Δ𝐼 Δ𝑌 − Δ𝐶 1 − Δ𝐶 1 − 𝑀𝑃𝐶 𝑀𝑃𝑆
Δ𝑌
Types of Investment

 Business fixed investment

 businesses’ 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
Business Fixed Investment

 The standard model of business fixed investment:

 the neoclassical model of investment

 Shows how investment depends on

 MPK (marginal product of capital)
 interest rate
 tax rules affecting firms
Two Types of Firms

 For simplicity, assume two types of firms:

1. Production firms rent the capital they use to produce

goods and services

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

 In this context, “investment” is the rental firms’

spending on new capital goods
The Capital Rental Market

real rental
Production firms capital
price, R/P
must decide how supply
much capital to
rent.

Competitive firms capital

rent capital to the demand
(MPK)
point where
equilibrium
MPK = R/P. rental rate
K
K capital
stock
Factors Affecting Rental Price

The equilibrium R/P would increase if:

K (e.g., earthquake or war)
L (e.g., pop. growth or immigration)
A (technological improvement, or
deregulation)
Rental Firm’s Investment Decision

 Rental firms invest in new capital when the

benefit of doing so exceeds the cost

 The benefit (per unit capital):

 R/P, the income that rental firms earn from renting the
unit of capital to production firms
Cost of Capital

 Components of the cost of capital:

 Interest cost: i PK, where PK = nominal price of
capital
 Depreciation cost:  PK, where  = rate of
depreciation
 Capital loss: − PK (a capital gain, PK > 0, reduces
cost of K )
 The total cost of capital is the sum of these
three parts
Taxes and Investment

Tax affecting investment:

 Corporate income tax
Residential Investment

 The flow of new residential investment, IH

 depends on the relative price of housing PH /P

 PH /P
is determined by supply and demand in
the market for existing houses
How Residential Investment is Determined

(a) The market for housing

Supply Supply and demand for

houses determines the
equilib. price of houses.

The equilibrium price of

houses then determines
residential investment:
Demand
KH
Stock of
housing capital
How residential investment is determined

(a) The market for housing (b) The supply of new housing

Supply PH
P
Supply

Demand
KH IH
Stock of Flow of residential
housing capital investment
How residential investment responds to a fall in
interest rates
(a) The market for housing (b) The supply of new housing

Supply PH
P
Supply

Demand
KH IH
Stock of Flow of residential
housing capital investment
Motives for Holding Inventories

1. Production smoothing
Sales fluctuate, but many firms find it cheaper to
produce at a steady rate.
 When sales < production, inventories rise.
 When sales > production, inventories fall.
2. Inventories as a factor of production
Inventories allow some firms to operate more
efficiently.
 samples for retail sales purposes
 spare parts for when machines break down
3. Stock-out avoidance
To prevent lost sales when demand is higher
than expected.
4. Work in process
Goods not yet completed are counted in
inventory.
Inventories and the Real Interest Rate

 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