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Chapter 2 The Data of Macroeconomics

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Chapter 2 The Data of Macroeconomics Powered By Docstoc
					        Investment demand




CHAPTER 11   Investment demand   slide 0
       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.

CHAPTER 11   Investment demand                slide 1
                                  U.S. Investment and its components, 1970-2002
                           2000
                                        PT       P P T
                                                  T                    PT              P
                           1750
Billions of 1996 dollars




                           1500

                           1250

                           1000

                            750

                            500
                            250

                              0

                           -250
                              1970      1975    1980     1985       1990     1995   2000
                                                 Total
                                                 Business fixed investment
                                                 Residential investment
                                                 Change in inventories
                                                                                           slide 2
       Types of Investment




CHAPTER 11   Investment demand   slide 3
Understanding business fixed investment
    The standard model of business fixed
     investment:
     the neoclassical model of investment
    Shows how investment depends on
     – MPK
     – interest rate
     – tax rules affecting firms




    CHAPTER 11   Investment demand          slide 4
           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 out to
     production firms.

                In this context,
        “investment” is the rental firms’
        spending on new capital goods.

 CHAPTER 11   Investment demand                  slide 5
How much the firm will choose to rent?
   The amount for which:
     Marginal benefit = Marginal Cost

  Marginal benefit – amount of dollars saved by using fewer of
    the other factors of production when more capital is employed
  Marginal cost – rental cost charged by the renting firm




   CHAPTER 11    Investment demand                                  slide 6
       The capital rental market
 dw




CHAPTER 11   Investment demand     slide 7
      The capital rental market
 Capital – diminishing marginal
  product of capital
 Marginal benefit of capital -
  demand curve for rented capital




 CHAPTER 11   Investment demand     slide 8
        How much capital?




CHAPTER 11   Investment demand   slide 9
     Effect of higher output

More output – rent more
capital




CHAPTER 11   Investment demand   slide 10
Rental firms’ investment decisions
  Rental firms invest in new capital when the
  benefit of doing so exceeds the cost.
                    The benefit:
         the income that rental firms earn
        from renting the unit of capital out
                to production firms.




  CHAPTER 11   Investment demand                slide 11
   The rental price of capital
Components of the cost of capital:
 • Price for purchasing a new machine from a
   producer of machines: PK – in “real terms”
 • Real interest rate - R
 • Rate of depreciation - 
 • Rental price of equipment – RK - amount
   received by the rental firm for renting out
   the machine for one year



CHAPTER 11   Investment demand                   slide 12
   The rental price of capital
Assume a rental firm decides to sell the
machine after one year in the rental
market:
-Beginning of year borrows PK to buy
the machine at interest rate R (interest
cost of RPK + cost of depreciation dPK
-Rental cost of a machine for one year:
=(R +d)PK
CHAPTER 11   Investment demand         slide 13
    The rental price of capital
Market rental price:
-The market rental price = cost of renting (if
rent below cost, rental firm go out of business,
if too high, new firms enter the rental business,
and price goes down)

                  RK =(R +d)PK
 Next: relate the demand for capital to
       the rental price of capital

 CHAPTER 11   Investment demand                slide 14
Demand for capital and rental price
  -Much of the US equipment is rented
  -The one year perspective we used to solve for the rental price is
  nor representative
  -The concern also involves the financial success of the project over
  long run
  -Therefore a firm has to formulate and evaluate investment
  projects: a project is a winner if the firm earns more than it would
  have to pay to borrow money to finance the project + pay to cover
  depreciation and a loser if it earns less than the rental price
  -! Diminishing marginal product of capital – eventually the winning
  project earns the borderline revenue – the rental price of capital.
  The firm uses capital up to the point where the marginal
  benefit of capital = rental price of capital

   CHAPTER 11     Investment demand                                slide 15
Expected changes in the future price of
              capital
  Up to now - PK does not change
  What if the price of capital goods is expected to change?
  – the forward looking aspects of the firm’s investment
  decision now become important!
  In general – the rental price is decreased by the amount
  of the expected increase in the price of capital, DPK

                    RK =(R +d)PK - DPK




   CHAPTER 11   Investment demand                      slide 16
           The cost of capital
For simplicity, assume DPK/PK = k
  (expected percentage change in the
  relative price of capital)

Then, the rental price becomes:

RK = PK(R + d  k)

The   real cost of capital depends positively on:
  •   the relative price of capital
  •   the real interest rate
  •   the depreciation rate

 CHAPTER 11    Investment demand                    slide 17
    The investment function
Investment demand function – how much capital
equipment the firm will purchase given its planned level of
output and the rental price of capital (firms have a
beginning stock, they examine the level of output and the
rental price, finally decide the level of capital)
Desired capital stock:
K* = 0.5(w/Rk)Y
W – wage rate
Y –firm level of output
Rk – rental price of capital

CHAPTER 11   Investment demand                           slide 18
    The investment function
How does the actual capital stock changes?
If no depreciation – level of investment increases capital stock by the
amount of investment:
I = K - K-1
If the firm wants to equal capital with desired capital:
I = K* - K-1
This much investment added to its existing capital gives the firm its
desired level of capital this year – investment demand function.
I = 0.5(w/Rk)Y - K-1
- Investment depends positively on the wage rate, negatively on the
rental price of capital and positively on output.


CHAPTER 11      Investment demand                                       slide 19
    The investment function
The effect of output on investment – accelerator

Assume 0.5(w/Rk) = v so K* = vY
K = vY (this year)
K-1 = vY-1 (last year)
I = vY – vY-1 = vDY – the level of investment I depends on
the change in output. When output accelerates, its change
gets bigger, investment is stimulated. A rise in output –
burst of investment, but if output remains high , investment
subsides.
The accelerator – explains a large fraction of movements in
investment.
CHAPTER 11     Investment demand                         slide 20
The investment function - properties

  1.   When growth of output high – I high
  2. When Rk high – investment low
  3. When wages are high – investment high
  4. The amount of replacement investment due to depreciation
     is a large fraction of investment each year –closely related to
     capital stock and output.
  5. Lags in putting new investment in place limit the response
     of investment to change sin its determinants (only certain
     types of investments are put in place first year)




 CHAPTER 11      Investment demand                               slide 21
      Taxes and Investment

  Two of the most important taxes
  affecting investment:
   1. Corporate income tax
   2. Investment tax credit




CHAPTER 11   Investment demand      slide 22
Corporate Income Tax: A tax on profits
Impact on investment depends on definition of “profits”
 • If the law used our definition (rental price minus cost
   of capital), then the tax doesn’t affect investment.
 • In our definition, depreciation cost is measured using
   the current price of capital.
 • But, legal definition uses the historical price of capital.
 • If PK rises over time, then the legal definition
   understates the true cost and overstates profit,
   so firms could be taxed even if their true economic
   profit is zero.
 • Thus, corporate income tax discourages investment.
     CHAPTER 11   Investment demand                       slide 23
The investment tax credit (ITC)
 The ITC reduces a firm’s taxes by a certain
 amount for each dollar it spends on capital
 Hence, the ITC effectively reduces PK
 which increases the profit rate and the
 incentive to invest.




CHAPTER 11   Investment demand              slide 24
      Permanent tax changes
 Assume that rental firm has to pay a tax rate of u on rental
  income. Also assume that the firm receives a payment of z
  dollars as an investment incentive from the government for
  each dollar of capital purchased.
       (1-u)RK = PK(R + d )(1-z) – after tax rental income =
  after tax costs benefits

(1-u)RK –after tax rental income

PK(1-z) – the cost of a purchasing a machine due to the effect
  of the investment incentives
The net effect of taxation: RK = PK(R + d )(1-z) / 1-u




 CHAPTER 11     Investment demand                                slide 25
     Anticipated tax changes
 Previously – tax rates are always in effect and tax
  changes are not anticipated by firms
 If firms are forward looking – anticipations can
  affect investment – but effects are tricky
 1. an anticipated elimination of the investment tax
  would increase investment in the year that the
  elimination was anticipated
 2.also opposite direction: If firms anticipated a
  reenactment of the investment tax credit , then
  rental price of capital would increase at the time of
  anticipation, and investment would fall.


 CHAPTER 11   Investment demand                           slide 26
       Financing constraints
 Neoclassical theory assumes firms can borrow
 to buy capital whenever doing so is profitable
 But some firms face financing constraints:
 limits on the amounts they can borrow
 (or otherwise raise in financial markets)
 A recession reduces current profits.
 If future profits expected to be high,
 it might be worthwhile to continue to invest.
 But if firm faces financing constraints,
 then firm might be unable to obtain funds
 due to current profits being low.
 CHAPTER 11   Investment demand                   slide 27
      Inventory Investment

     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.




CHAPTER 11   Investment demand                slide 28
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.




 CHAPTER 11   Investment demand                 slide 29
Motives for holding inventories
1. production smoothing

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




 CHAPTER 11   Investment demand              slide 30
Motives for holding inventories
1. production smoothing

2. inventories as a factor of production

3. stock-out avoidance
   To prevent lost sales in the event of higher
   than expected demand.




 CHAPTER 11   Investment demand               slide 31
Motives for holding inventories
1. production smoothing

2. inventories as a factor of production

3. stock-out avoidance

4. work in process
   Goods not yet completed are counted as
   part of inventory.




 CHAPTER 11   Investment demand             slide 32
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.
  Example:
   High interest rates in the 1980s motivated
   many firms to adopt just-in-time production,
   which is designed to reduce inventories.

  CHAPTER 11   Investment demand                  slide 33

				
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