INVESTMENT SPENDING & CAPITAL FORMATION

1. 4 • INVESTMENT SPENDING & CAPITAL FORMATION

2. Income and Consumption—LCH death Saving Consumption Income Dissaving T

3. Investment • Investment has always been high on the economics research agenda for many reasons. In particular: • In the short run, investment expenditures represent • a significant source of volatility in business cycle fluctuations. Fluctuations in investment account for much of the year-to-year change in GDP. • (2) In the long run, investment can be an "engine" of growth to greater productivity and wealth. Countries that invest a greater share of their GDP generally exhibit higher economic growth rates

4. Real GDP growth rate • Investment growth rate • Consumption growth rate Growth rates of real GDP, consump., investment • Percent change from 4 quarters earlier

5. International evidence on investment rates and income per person Income per person in 2010 (log scale) Investment as percentage of output (average 1960-2010)

6. Capital and Interest • Investment and Capital • The capital stock is the total amount of plant, equipment, buildings, and inventories, or physical capital. • Gross investment is the purchase of new capital. • Depreciation is the wearing out of the capital stock. • Net investment equals gross investment minus depreciation, and net investment is the addition to the capital stock.

7. Gross Investment, Net Investment, and Depreciation • Investment is the flow of spending that adds to the physical stock of real capital. We begin the year with some level of capital and we end the year at some different level: • Int = Kt – Kt-1 where, • Int = net investment in period t • Kt = capital stock at the end of period t, and • Kt-1 = capital stock at the end of period t-1 (start of period t) • The above specification ignores depreciation. Physical capital wears out and becomes obsolete. Some additional investment spending must be directed to the replacement of depreciating capital.

8. Gross Investment, Net Investment, and Depreciation • The Commerce Department reports depreciation as "consumption of fixed capital." • A common assumption is that the depreciation rate is a fixed fraction of the level of capital (capital depreciates geometrically at a constant rate), and replacement investment is: • Irt = δ Kt-1 • Irt = investment in replacement capital in period t • δ = depreciation rate • Total gross investment is the sum of net investment and replacement investment: • Igt = Int + Irt = Kt – Kt-1 + δ Kt-1 = Kt - (1 - δ ) Kt-1 • Igt = gross investment in period t

9. Sources of Investment • Saving • Saving is current income minus current expenditure, and in part finances investment. Investment is financed by national saving and borrowing from the rest of the world. • Personal saving is personal disposable income minus consumption expenditure. • Business saving is retained profits and additions to pension funds by businesses. • Government saving is the government’s budget surplus. • Any of these components can be negative.

10. Investment Expenditures • The National Income and Product Accounts (NIPA) includes these categories of investment expenditures: • Nonresidential fixed investment - goods used for future use in production processes, including: • Structures - factories, office buildings, warehouses, and other structures in which the production of goods and services takes place. • Equipment and software - any business equipment that is expected to last more than one year such as computers, office furniture, machinery, tools, cars, trucks, etc. • Residential fixed investment - new housing that people buy to live in and landlords buy to rent out. • Change in inventories - goods in storage that will be used to produce other goods, including raw materials, work-in-process, and finished products. A decline in inventories is recorded as negative investment.

12. Total investment • Business fixed investment • Residential investment • Change in inventories U.S. Investment and its components, 1970–2014 • Billions of current dollars

13. 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

14. 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.

15. The capital rental market Production firms must decide how much capital to rent. Recall thatCompetitive firms rent capital to the point where MPK = R/P. • real rental price, R/P • capital supply • capital demand (MPK) • equilibrium rental rate • K • capital stock

16. 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(e.g., earthquake or war) • L(e.g., pop. growth or immigration) • A(technological improvement, or deregulation)

17. Neoclassical Investment Model • The neoclassical investment model takes a more rigorous approach to estimating the desired level of capital. • Building from the microeconomic model of the firm's production function and profit-maximizing behavior we can relate the desired level of capital and investment to product prices (demand) and interest rates. • We also improve on the simple accelerator model by explicitly accounting for the reality that it takes time to build new plant and equipment.

18. Rental firms’ investment decisions 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.

19. The 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:

20. The cost of capital Example: car rental company (capital: cars) Suppose PK = $10,000, i = 0.10,  = 0.20, and PK/PK = 0.06 Nominal cost of capital • Then, interest cost = depreciation cost = capital loss = total cost = • $1000 • $2000 •  $600 • $2400

21. The cost of capital For simplicity, assume PK/PK = . Then, the nominal cost of capital equalsPK(i +   ) = PK(r + ) and the real cost of capital equals The real cost of capital depends positively on: • the relative price of capital • the real interest rate • the depreciation rate

22. The rental firm’s profit rate A firm’s net investment depends on its profit rate: • If profit rate > 0, then increasing K is profitable • If profit rate < 0, then the firm increases profits by reducing its capital stock(i.e., not replacing capital as it depreciates)

23. Net investment & gross investment Hence, where In[ ] is a function that shows how net investment responds to the incentive to invest. Total spending on business fixed investment equals net investment plus replacement of depreciated K:

24. The investment function An increase in r: raises the cost of capital reduces the profit rate and reduces investment: • r • r1 • I • I1 • r2 • I2

25. The investment function An increase in MPKor decrease in PK/P increases the profit rate increases investment at any given interest rate shifts I curve to the right. • r • r1 • I • I2 • I1

26. Taxes and investment Two of the most important taxes affecting investment: Corporate income tax Investment tax credit

27. Tobin’s q • numerator: the stock market value of the economy’s capital stock. • denominator: the actual cost to replace the capital goods that were purchased when the stock was issued. • If q > 1, firms buy more capital to raise the market value of their firms. • If q < 1, firms do not replace capital as it wears out.

28. Relation between q theory and neoclassical theory • The stock market value of capital depends on the current & expected future profits of capital. • If MPK > 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 < cost of capital, then firms are incurring losses, so their stock market values fall, so q is low.

29. The stock market and GDP Reasons for a relationship between the stock market and GDP: 1. A wave of pessimism about future profitability of capital would: • cause stock prices to fall • cause Tobin’s q to fall • shift the investment function down • cause a negative aggregate demand shock

30. The stock market and GDP Reasons for a relationship between the stock market and GDP: 2. A fall in stock prices would: • reduce household wealth • shift the consumption function down • cause a negative aggregate demand shock

31. Models of Investment • Four models of investment: • Net Present Value - this is one of the standard "Business School" approaches to how individuals compare different opportunities when making investment decisions. While it is not a model that can be directly applied to macroeconomic models it does provide insight into the relationships of investment to demand, prices and interest rates. • Simple Accelerator Model - one of the most basic macroeconomic investment models, the simple accelerator model relates investment (changes in the level of the capital stock) to changes in demand. This model of investment is frequently applied to modeling inventory behavior. • Neoclassical with Flexible Accelerator Model - a more rigorous approach to determining the desired level of capital stock and the rate of investment to reach that desired level of capital. The resulting flexible accelerator model is similar to the simple accelerator model, but adds interest rates and expected inflation to demand as explanatory variables. • q-Theory- economists don't completely ignore the stock market. One of the problems in estimating investment models and forecasting is that some variables are not directly observable. We generally know how much capital costs, but how much is capital worth? The stock market provides an indication.

32. The Simple Accelerator Model • Attempts to capture some measure of current business conditions (growth of the economy or lack of it), and use that to explain the level of investment. • It is a model of business investment that in its simplest form relates the level of investment to the rate of change in output. • The desired capital stock is proportional to the level of output:

33. Accelerator Model • We assume that whatever the capital stock ended up being last period was the level of capital that businesses actually wanted:

34. Accelerator Model • This allows us to rewrite: • As • Thus investment is related to the rate of change in output. • If the economy is growing rapidly, then investment grows rapidly. • If the economy is not growing, then investment slows, and net investment (after depreciation) may actually be negative.

35. The Flexible Accelerator Model • As a result of adjustment costs and practical time-to-build considerations, the entire adjustment to the desired capital stock may not be done in one period. The firms may only finance a partial adjustment. • Let  be the fraction of the gap between the desired and actual capital stock that the firms pursue. This leads to:

36. Tobin’s q • The neoclassical model provides insight on how to estimate the cost of capital using observable variables but provides little guidance on how to determine the benefit of using real capital. The neoclassical model assumes that the technology, or the marginal product of capital, is known. Unfortunately for economists this usually isn't the case. • Nobel laureate James Tobin suggested a possible solution--use the value of capital as revealed in the stock market. If the total market value of a firm's stocks and bonds exceeds the cost of replacing all of the capital it owns, this implies the value of its capital is greater than the cost of acquiring it. • Tobin's q - the market value of installed capital divided by the replacement cost of installed capital.

37. THE END