Investment
Financial vs physical capital In the consumption-saving model studied earlier, we studied the role of financial capital and investment. Financial capital consists of IOUs like stocks, bonds, and money. Financial capital may facilitate production of final goods and services, but does not directly produce output. In contrast, physical/human capital serves as an input in the production process. Think of physical capital as an intertemporal production technology.
Investment Investment refers to newly produced capital goods. machinery, inventory, homes, office buildings, roads, sewers, maintenance and repair. NIPA only records investment in non-human forms of capital. in reality, human capital investment is hugely important. But physical capital is obviously important too (just look around you). Most of the business cycle is accounted for by swings in investment.
Intertemporal production How might Robinson Crusoe transport coconuts today into the future? In the consumption-saving model, RC transported his private consumption into the future at the expense of his debtor s consumption no additional output was produced. But suppose RC can physically transport his coconuts to the future? e.g., by planting a coconut or holding it as inventory. this can be done even independently of financial markets.
The investment demand function Suppose that units of investment today yields an expected output ( ) ( ) is an increasing and strictly concave function, 0 ( ) 0 00 ( ) 0 is an expected productivity parameter. 0 ( ) is the expected marginal product of investment (future capital). an increasing function of and a decreasing function of
The investment demand function Let denote the gross real rate of interest. Expected net present value (NPV) of capital spending is given by ( ) = ( + ( ) ) The investment demand function ( ) maximizes ( ) i.e., 0 ( )= 0 or 0 ( )= is a decreasing function of and an increasing function of
Stock market value Define ( ) ( ( )) Can interpret as the value of business sector capital (corporate stocks and bonds). is a decreasing function of and an increasing function of Re: increase in = good news and decrease in = bad news. Good news leads to boom in desired capital spending and stock market values.
Investment and saving Earlier, we studied the consumption-saving choice of Robinson Crusoe assuming only financial capital. Suppose now that RC can invest in domestic capital. GDP flow is now given by { 1 2 } = { ( )} Consumption-saving decision is solution to max ( 1 2 ) subject to 1 + 2 + ( )
Investment and saving Solution implies a desired domestic saving function ( ) is increasing in increasing in and decreasing in note: an increase in and elicits a weaker response in desired saving than changes in or individually (why?). Recall + + + and implies + In our model, = ( ) ( )
Closed economy In a closed economy, =0so that saving must equal investment ( ) = ( ) One can think of equation above as defining an IS curve combinations of ( ) that are consistent with = Alternatively, one can think of IS curve as representing the aggregate demand for output as a function of and This framework can accommodate many different views of the business cycle.
Classical view Level of is determined in labor market, largely independent of and In this case, ( )= ( ) determines the equilibrium interest rate Fluctuations in reflect rational changes in expectations, inducing cyclical fluctuationincapitalspending,stockmarket valuations, and interest rates. No obvious role for government stabilization policies.
Keynesian view Level of is determined by aggregate demand, a function of and In this case, ( )= ( ) determines equilibrium level of But may be either too high or too low because market expectations can be overly optimistic or pessimistic (animal spirits). Stabilization policies are desirable, e.g., lower (add stimulus) if overly pessimistic decline in.