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CHAPTER 18
Investment

A PowerPointTutorial
To Accompany

MACROECONOMICS, 7th. ed.
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
Chapter Eighteen                                                              1
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
Chapter Eighteen   2
• Business fixed investment includes the equipment and

• Residential investment includes the new housing that
people buy to live in and that landlords buy to rent out.

• Inventory investment includes those goods that businesses
put aside in storage, including materials and supplies, work
in progress, and finished goods.

Chapter Eighteen                                            3
The standard model of business fixed investment is called the
neoclassical model of investment. It examines the benefits and costs of
owning capital goods. Here are three variables that shift investment:

1) the marginal product of capital
2) the interest rate
3) tax rules

To develop the model, imagine that there are two kinds of firms:
production firms that produce goods and services using the
capital that they rent and rental firms that make all the
investments in the economy.

Chapter Eighteen                                               4
To see what variables influence the equilibrium rental price, let’s
consider the Cobb-Douglas production function (recall in Chapter 3) as
a good approximation of how the actual economy turns capital and labor
into goods and services. The Cobb-Douglas production function is:
Y = AKaL1-a , where Y is output, K capital, L labor, and a a parameter
measuring the level of technology, and a a parameter between 0 and 1
that measures capital’s share of output. The real rental price of capital
adjusts to equilibrate the demand for capital and the fixed supply.
Capital supply

Capital demand (MPK)
Chapter Eighteen                                           5
K     Capital stock, K
The marginal product of capital for the Cobb-Douglas production
function is MPK = aA(L/K)1-a. Because the real rental price equals the
marginal product of capital in equilibrium,
we can write R/P = aA(L/K)1-a . This expression identifies the variables
that determine the real rental price. It shows the following:

• the lower the stock of capital, the higher the real rental price of capital
• the greater the amount of labor employed, the higher the real rental
price of capitals
• the better the technology, the higher the real rental price of capital.

Events that reduce the capital stock, or raise employment, or improve
the technology, raise the equilibrium real rental price of capital.

Chapter Eighteen                                                   6
Let’s consider the benefit and cost of owning capital.
For each period of time that a firm rents out a unit of capital, the rental
firm bears three costs:
1) Interest on their loans, which equals the purchase price of a unit of
capital PK times the interest rate, i, so i PK.
2) The cost of the loss or gain on the price of capital denoted as -DPK .
3) Depreciation d defined as the fraction of value lost per period
because of the wear and tear, so d PK .
Therefore the total cost of capital = i PK - DPK + dPK or
= PK (i - D PK/ PK + d)
Finally, we want to express the cost of capital relative to other goods in
the economy. The real cost of capital—the cost of buying and renting
out a unit of capital measured in terms of the economy’s output is:
The Real Cost of Capital = (PK / P )(r + d), where r is the real interest
rate and PK / P equals the relative price of capital. To derive this
equation, we assume that the rate of increase of the price of goods in
Chapter Eighteen                                                  7
general is equal to the rate of inflation.
Now consider a rental firm’s decision about whether to increase or
decrease its capital stock. For each unit of capital, the firm earns real
revenue R/P and bears the real cost (PK / P )(r + d).
The real profit per unit of capital is:
Profit rate = Revenue - Cost
= R/P        - (PK / P )(r + d)
Because the real rental price equals the marginal product of capital, we
can write the profit rate as:
Profit rate = MPK - (PK / P )(r + d)
The change in the capital stock, called net investment depends on the
difference between the MPK and the cost of capital. If the MPK exceeds
the cost of capital, firms will add to their capital stock. If the MPK
falls short of the cost of capital, they let their capital stock shrink, thus:
DK = In [MPK - (PK / P )(r + d)],
where In ( ) is the function showing how much net investment responds
Chapter Eighteen                                                    8
to the incentive to invest.
We can now derive the investment function in the neoclassical model of
investment. Total spending on business fixed investment is the sum of
net investment and the replacement of depreciated capital.
The investment function is:

I = In [MPK - (PK / P )(r + d)] + dK.

the cost of capital
depends on                         amount of depreciation

Investment              marginal product of capital

This model shows why investment depends on the real interest rate.
A decrease in the real interest rate lowers the cost of capital.
Chapter Eighteen                                                        9
Notice that business fixed investment increases when the interest rate
fall—-hence the downward slope of the investment function. Also,
an outward shift in the investment function may be a result of an
increase in the marginal product of capital.

Investment, I

Chapter Eighteen                                              10
Finally, we consider what happens as this adjustment of the capital
stock continues over time. If the marginal product begins above the
cost of capital, the capital stock will rise and the marginal product will
fall. If the marginal product of capital begins below the cost of capital,
the capital stock will fall and the marginal product will rise.
Eventually, as the capital stock adjusts, the MPK approaches the cost
of capital. When the capital stock reaches a steady state level,
we can write:

MPK = (PK / P )(r + d).

Thus, in the long run, the MPK equals the real cost of capital. The
firms adjust their capital stock, which in turn depends on how costly
it is to build, deliver, and install new capital.
Chapter Eighteen                                                  11
Policymakers often change the rules governing corporate income
tax in an attempt to encourage investment, or at least mitigate the
disincentive the tax provides.

An investment tax credit is a tax provision that reduces a firm’s
taxes by a certain amount for each dollar spent on capital goods.

Because a firm recoups part of its investment in capital goods in the
form of lower taxes, a credit reduces the effective purchase price of
a unit of capital P.

Chapter Eighteen                                                12
The term stock refers to the shares in the ownership of corporations, and
the stock market is the market in which these shares are traded.
The Nobel-Prize-winning economist James Tobin proposed that firms
base their investment decisions on the following ratio, which is now
called Tobin’s q:

q = Market Value of Installed Capital
Replacement Cost of Installed Capital

Chapter Eighteen                                               13
The numerator of Tobin’s q is the value of the
economy’s capital as determined by the stock market.
The denominator is the price of capital as if it were
purchased today. Tobin conveyed that net investment
should depend on whether q is greater or less than 1. If
q >1, then firms can raise the value of their stock by
increasing capital, and if q < 1, the stock market values
capital at less than its replacement cost and thus, firms
will not replace their capital stock as it wears out.
Tobin’s q measures the expected future
profitability as well as the current profitability.

Chapter Eighteen                                                    14
1) Higher interest rates increase the cost of capital and reduce business
fixed investment.

2) Improvements in technology and tax policies, such as the corporate
income tax and investment tax credit, shift the business fixed-
investment function.

3) During booms higher employment increases the MPK and therefore,

Chapter Eighteen                                                15
Efficient-Market Hypothesis: the market price of a company’s
stock is the fully rational valuation of the company’s value, given

Keynes’ beauty contest is a metaphor for stock speculation. In this
view, the stock market fluctuates for no good reason, and because the
stock market influences the aggregate demand for goods and services,
these fluctuations are a source of short-run economic fluctuations.

Chapter Eighteen                                               16
We will now consider the determinants of
residential investment by looking at a simple
model of the housing market. Residential
investment includes the purchase of new
housing both by people who plan to live in
it themselves and by landlords who plan to rent
it to others.

There are two parts to the model:
1) the market for the existing stock of houses determines the
equilibrium housing price
2) the housing price determines the flow of residential investment.
Chapter Eighteen                                                17
The relative price of housing adjusts to equilibrate supply and demand
for the existing stock of housing capital. The relative price then
determines residential investment, the flow of new housing that
construction firms build.

Demand
Stock of housing capital, KH    Flow of residential investment, IH
Chapter Eighteen                                             18
When the demand for housing shifts, the equilibrium price of housing
changes, and this change in turn affects residential investment.
An increase in housing demand, perhaps due to a fall in the interest
rate, raises housing prices and residential investment.

Demand'
Demand
Stock of housing capital, KH    Flow of residential investment, IH
Chapter Eighteen                                             19
1) An increase in the interest rate increases the cost of borrowing
for home buyers and reduces residential housing investment.
2) An increase in population and tax policies shift the residential
housing-investment function.
3) In a boom, higher income raises the demand for housing and
increases residential investment.

Chapter Eighteen                                                20
Inventory investment, the goods that businesses put aside
in storage, is at the same time negligible and of great
significance. It is one of the smallest components of
spending—but its volatility makes it critical in the study
of economic fluctuations.

Chapter Eighteen                                                  21
When sales are high, the firm produces less that it sells
and it takes the goods out of inventory. This is called
production smoothing. Holding inventory may allow
firms to operate more efficiently. Thus, we can view
inventories as a factor of production. Also, firms don’t
want to run out of goods when sales are unexpectedly
high. This is called stock-out avoidance. Lastly, if a
product is only partially completed, the components are
still counted in inventory, and are called, work in
process.

Chapter Eighteen                                           22
The accelerator model assumes that firms hold a stock of
inventories that is proportional to the firm’s level of output. Thus, if
N is the economy’s stock of inventories and Y is output, then
N=bY
where b is a parameter reflecting how much inventory firms wish to
hold as a proportion of output. Inventory investment I is the change in
the stock of inventories DN. Therefore, I = DN = b DY.

Chapter Eighteen                                                23
The accelerator model predicts that inventory investment is
proportional to the change in output.
• When output rises, firms want to hold a larger stock of inventory,
so inventory investment is high.
• When output falls, firms want to hold a smaller stock of inventory,
so they allow their inventory to run down, and inventory investment
is negative.
The model says that inventory investment depends on whether the
economy is speeding up or slowing down.

Chapter Eighteen                                                24
Like other components of investment, inventory investment depends
on the real interest rate. When a firm holds a good in inventory and
sells it tomorrow rather than selling it today, it gives up the interest it
could have earned between today and tomorrow. Thus, the real
interest rate measures the opportunity cost of holding inventories.

When the interest rate rises, holding inventories becomes more
costly, so rational firms try to reduce their stock. Therefore, an
increase in the real interest rate depresses inventory investment.

Chapter Eighteen                                                   25
1) Higher interest rates increase the cost of holding inventories and
decrease inventory investment.

2) According to the accelerator model, the change in output shifts
the inventory investment function.

3) Higher output during a boom raises the stock of inventories firms
wish to hold, increasing inventory investment.

Chapter Eighteen                                                26
Residual investment                Tobin’s q
Inventory investment               Financing constraints
Neoclassical model of investment   Production smoothing
Depreciation                       Inventories as a factor of
Real cost of capital                      production
Net investment                     Stock-out avoidance
Corporate income tax               Work in process
Investment tax credit              Accelerator model
Stock

Chapter Eighteen                                              27

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