Investment. Lecture 2

Transcription

1 Investment Lecture 2

2 Investment The share of investment spending in GNP is much smaller than that of consumption Investment spending varies among nations but its average is usually between 15 % to 35 % of GNP Investment spending is much more volatile than consumption spending At times, especially in the early days of a recession the fall in investment spending may even be larger than the total fall in income Now we take a close look at investment spending In order to reach a better understanding of the investment function which plays such a critical role in macroeconomic theory 2

3 Types of investment spending National income accounting distinguishes three basic categories of investment spending Business fixed investment includes all equipment and structures purchased by firms for use in the production of goods and services Residential investment includes the new housing that consumers or firms buy buy to live in or to rent Inventory investment includes those goods that businesses keep as stocks, such as materials and supplies, work in progress and finished goods In Turkey, GNP data distinguish between public and private investment, plus between equipment-machinery and buildings-construction 3

4 US: Investment data 4

5 Turkey: total investment spending Billion TL 1987 prices Q1 1990Q2 1993Q3 1996Q4 2000Q1 2003Q2 2006Q3 Investment EC 201 Week 11 5

6 Turkey: investment spending in GNP 30 % (Current Prices) Q4 1990Q3 1993Q2 1996Q1 1998Q4 2001Q3 2004Q2 2007Q Investment/GNP Investment/GNP (inc. inventories) EC 201 Week 11 6

7 Turkey: public-private investment Billion TL 1987 prices Q4 1990Q2 1992Q4 1995Q2 1997Q4 2000Q2 2002Q4 2005Q2 Pub. Inv. EC 201 Week Pri. Inv. 11 Inventories 7

8 Turkey: components of investment Billion TL (1987 Prices) Q4 1990Q3 1993Q2 1996Q1 1998Q4 2001Q3 2004Q2 2007Q1 Equipment (Private + Public) Construction (Private + Public) EC 201 Week 11 8

9 Business fixed investment It is the largest portion of investment spending Anything that is bought for firms for use in future production is included in this category It has two important sub-categories: Machines and equipment include everything inside the factories, plants, shops, offices, etc. Construction includes all the structures where machines and equipment are housed Exemple: spending for a dam is under the item construction, spending for the turbines, transformers, etc. is under the item equipment In Turkey both are given seperately for public and private sectors 9

10 Neoclassical model of investment The standart explanation of business investment is called neoclassical The model proceeds by comparing the benefits and costs to firms of owning capital goods To establish benefits, it uses the production function to derive the marginal product of capital Interest rate is taken as the cost of capital Level of investment is therefore determined by the marginal product of capital and the interest rate It distinguishes between owning capital (rental firm) and using it to produce something (production firm) In real life, most firms assume both roles at the same time 10

11 Rental price of capital The demand for equipment come from firms set with the intention to produce a good or service As long as the rental price of equipment is lower than its marginal product, firms make profits by renting equipment for production The marginal product curve of capital equipment therefore becomes the demand curve We can assume that the supply of equipment is fixed in the short run (vertical supply curve) Rental price of capital will be determined at the intersection of demand and supply curves The Cobb-Douglas production function will facilitate our understanding of this process 11

12 Rental price of capital 12

13 Cobb-Douglas production function Cobb-Douglas is a computable production function with constant returns to scale exhibiting all the characteristics of neoclassical production function Y = A K L 1- Marginal product of capital becomes MPK = A ( L / K ) 1- MPK is equal to the rental price R / P = A ( L / K ) 1- The lower the capital stock, higher is its rental price The greater the labour employed, higher is the rental price of capital The better the technology, higher is the rental price of capital 13

14 Cost of capital A rental firm must pay interest on capital equipment it buys with the intention to rent to production firms If P K is the purchase price of the equipment and i the nominal interest rate, i P K is the interest cost of buying equipment with the intention to rent Potential changes in the prices of equipment must be covered by the rental price - P K is the loss or gain on price changes (negative because it is a cost item) Wear and tear of equipment, called depreciation will be a fixed fraction of value: P K Total cost of capital now becomes Cost of capital = i P K - P K + P K 14

15 Determinants of investment The real cost of capital is obtained by dividing the equation by the price level P and substituting the real interest rate for the nominal interest rate Real cost of capital = ( P K / P ) (r + ) The difference between the rental price and the real cost of capital is the profit of the rental firm Profit rate = MPK ( P K / P ) (r + ) The rental firm will continue buying equipment (investing) until the marginal product of capital is equal to its real cost Gross investment spending becomes K = I n [MPK ( P K / P ) (r + ) ] 15

16 The investment function From investment spending we can deduce the investment function I = I n [MPK ( P K / P ) (r + ) ] + K The first part is net investment while the second part is replacement investment corresponding to the wear and tear (depreciation) in capital equipment Changes in the real interest rate will cause changes in investment spending Higher interest rates will reduce investment while lower interest rates will increase it This gives us a downward sloping investment curve The curve will shift with changes in technology and real wages 16

17 The investment function 17

18 Taxes and investment Until now we neglected taxes on capital income Obviously, tax laws will influence investment Corporate tax (kurumlar vergisi) is levied on the profits of firms, therefore on rental income A fall in corporate tax will increase the net profit from an investment and therefore acts as an incentive to invest High inflation without inflation accounting cause overstatement of profits for firms and higher taxes constitute a disincentive for investment Many countries permit investment credits against taxes (vergi muafiyeti) to firms in order to encourage investment 18

19 Stock market and Tobin s q An alternative interpretation was offered by James Tobin, a Nobel prize winner His hypotesis links the fluctuations in the stock market with the fluctuations in investment Firms invest more when stock prices are high, less when they are low, depending on whether the formula below is less or bigger than one q = Market value of installed capital Replacement cost of installed capital High market value is both a signal and incentive for firms to undertake capital spending It also means that firms do not face financing constraints for investment spending 19

20 Stock market as an indicator 20

21 Banking crisis and credit crunch Crisis in the banking sector have always and everywhere implied serious downturns in economic activity and investment spending Great Depression of 1930s and the recent global crises are good examples When the balance sheets of banks are unhealthy they stop lending to firms, which in turn are forced to cut down investment spending Credit crunch refers to the lack of availability of credit financing for firms Turkey experienced a fall in real bank credits to the private sector after 2001 Fears of a similar problem recently surfaced in US 21

22 Residential investment Investment in new houses is an important item of spending in every country In Turkey, private sector investment in housing fluctuated between 7 and 9 % of GNP until 1999 Since 1999, GNP date shows residential and non-residential construction as a single item Residential investment poses a a stock and flow issue due to lags of the construction business At any moment, house prices are determined by the demand for housing and the stock of houses But in the long run the level of house prices will determine the flow of housing supply Which will constitute future stocks of houses 22

23 Stock and flow in housing 23

24 An increase in housing demand 24

25 Housing demand and interest rate In countries with developed financial sectors and low inflation demand for housing is very closely related to the interest rate Because consumers finance their house purchases with long term loans of 20 or 30 years (also called mortgage ) from banks and other specialised financial intermediaries A fall in long term interest rates imply a reduction in the monthly instalments paid by consumers for the loan and acts like an incentive to buy a house An increase in long term interest rates imply higher monthly instalments and reduces the willingness to buy houses 25

26 Housing demand and interest rates 26

27 Inventory investment The effects of changes in inventories are normally negligeable but at times of great significance It is not the absolute level of inventories but the change that is captured by national income accounts Inventories are used by firms to smooth the level of production over time Inventories can also be considered a factor of production: spare parts permit fast repair Inventories allow firms to avoid stock-out when faced with unexpected jump in sales Usually, production takes time and firms have unfinished and semi-finished products as work in progress 27

28 The accelerator model of investment The accelerator model assumes that firms keep inventories proportional to output N = Y Inventory investment is change in N I = N = Y The results are interesting: if output remains constant, inventory investment is zero But when output goes up and down inventory investment varies in the same direction In other words it amplifies the fluctuations in output during booms and recession is calculated to be 0.2 for the US economy: a fall in demand of 1 $ cuts spending further by 0.2 $ 28

29 US: inventory investment 29

30 Turkey: inventory accelerator Changes in inventories aggravate the recessions and recoveries in Turkish business cycles but have very little effect in normal times In times of economic crisis, falls in inventories explain a large portion of the fall in GNP During a recovery, increases in inventories make major contributions to the growth of GNP Contribution to growth of a spending item is calculated by multiplying its growth rate with its share in GNP It shows the change in GNP that can be attributed to that spending item Figures since 2001 are very interesting 30

31 12 Turkey: inventory accelerator % Q Q4 1994Q4 1997Q4 2000Q4 2003Q4 2006Q Inventory Inv. (Contr.to growth) GNP Growth Rate 31

32 Questions