MACROECONOMICS II INVESTMENT DEMAND (SPENDING) Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 1
In macroeconomics, Investment Demand is important for two reasons: 1) Volatile and hence responsible for much fluctuations in GDP across the business cycle. 2) Because of its link with interest rates, it is a means by which fiscal and monetary policy affects the economy. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 2
Investment spending links the present to the future, in that, it offers the possibility today of raising standards of living in the future. Consequently, the average level of Investment spending (by adding to the capital stock) plays a key role in long-run economic growth. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 3
Three types of Investment demand can be identified: 1) Business fixed investment (the K in the production function). 2) Residential investment (new housing). 3) Inventory investment (goods businesses put in storage, including materials and supplies, work-in-progress and finished goods) Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 4
Typically, business fixed investment is the largest component of investment spending in an economy. Whilst inventory investment is considerably smaller than the other two. Nevertheless, all three are volatile. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 5
Before we begin, a note on terminology! Investment in macroeconomics is the flow of spending that adds to the physical stock of capital. Capital stock is the money value of all buildings, machines, and inventories at a point in time. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 6
Thus, it is worth noting that the theories that we discuss for all the three types of investment spending emphasise two elements: 1. The demand for capital, and 2. Investment as a flow which adds to the level of the capital stock. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 7
Business Fixed Investment: The Neoclassical Approach Here we go beyond the simple investment function, I = I (r), to examine the role of output, financial constraints and taxes in determining investment. We also look at how policy affects investment. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 8
The neoclassical model examines the benefits and costs to firms of owning capital goods. Two simply our analysis we assume two firms, Production Firms and Rental Firms. In reality, most firms act as both. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 9
Production firms produce goods and services using capital they rent. Rental firms make all the investment in the economy; they buy capital and rent it out to production firms. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 10
The typical production firm rents out capital in order to produce goods and services, and weighs the benefits and costs associated with this decision. The firm rents capital at R and sells goods at a market price P. The real cost of production is defined as R/P. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 11
The real benefit of capital is the marginal product of capital, MPK, which is the increase in output produced by using 1 more unit of capital. We know from microeconomic theory, that the MPK declines as more capital is used in production. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 12
As a profit maximizing firm, it aims to equate the benefits to costs, or equate the marginal product of capital to the rental price of capital (cost of capital). As long as the value of the marginal product of capital is above the real rental price of capital, it pays the firm to add to its capital stock. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 13
In the next slide we illustrate equilibrium in the market for rental capital. The marginal product of capital determines the demand curve; it slopes downwards because the MPK is low when the level of capital is high. At any point in time the supply of capital is fixed, so the supply is vertical Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 14
Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 15
What influences the equilibrium real rental price? We begin by considering a typical production function: Y is output, A measures technology, K is capital input, L is labour input. L 1 0 1; measures capital s share of Y Y AK Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 16
The MPK can defined as In equilibrium: Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 17 1 K L A MPK 1 K L A P R
The expression below identifies the variables that determine the Real Rental Price of Capital. R P A L K 1 Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 18
1) The lower the stock of capital, the higher the real rental price of capital. 2) The greater the amount of labour employed, the higher the real rental price of capital. 3) The better the technology, the higher the rental price of capital. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 19
The Cost of Capital We now consider the case of Rental firms. As with Production firms, we consider the benefits and costs of owning capital. The benefits come from the revenues earned by renting out capital, and thus receives a rental price of R/P. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 20
In respect of the costs, we like to think of the firm as financing the purchase of capital by borrowing. However, for each period of time that the Rental firm rents outs a unit of capital, it bears three costs. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 21
1. When the firm borrows to buy capital, it must pay interest on the loan. If P K is the purchase price, then ip K is the interest cost. (note the interest cost will be the same even if the firm doesn t borrow). 2. Because the price of capital can change while the firm rents out, there could be a gain or loss ( P K ), here representing cost. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 22
3. While the capital is rented out, it suffers depreciation. If is the rate of depreciation, then the cost of P K depreciation is. The total cost of renting out can therefore be given by (see next slide) Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 23
C ip K P K P K C P K ( i P P ) K K Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 24
The cost of capital depends on the price of capital, the interest rate, the rate at which capital prices are changing, and the depreciation rate. To make our lives even easier, we assume that the prices of capital goods rises with the prices of other goods. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 25
In that case, we can redefine the rate of change in the price of capital as the inflation rate, hence P P K K We also know that the real rate of interest can be defined as r i Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 26
In that case the cost of capital, C, can be defined as: C P K ( r ) This states that the cost of capital depends on the price of capital, the real interest rate and the rate of depreciation. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 27
We can also express the cost of capital relative to other goods in the economy: Real Cost of Capital = P K P ( r ) This states that the real cost of capital depends on the relative price of a capital good, the real Interest rate and the rate of depreciation. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 28
The Determinants of Investment Now we consider the situation in which the rental firm decides whether to increase or decrease the capital stock. We know that for each unit of capital, the firm earns real revenue and bears real cost. The real profit per unit of capital is: Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 29
Profit Rate = Revenue Cost Profit Rate = R P P K P ( r ) Because R P MPK in equilibrium, the profit rate can be stated as: Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 30
Profit Rate = MPK P K P ( r ) The Rental firm makes a profit if the marginal product of capital is greater than the cost of capital. It makes a loss if the opposite holds. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 31
Thus we see that whether a Rental firm adds to the capital stock or allows it to depreciate depends on whether owning and renting out capital is profitable. The change in capital stock is defined as net investment. The same conclusion applies to a firm that both uses and owns capital. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 32
In other words, whether a firm actually buys its own capital or leases it, the cost of capital (rental cost) is the right measure of the opportunity cost. Remember, resources have alternative uses! Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 33
That is, for such a firm additions to the capital stock depends on whether it is profitable or not. In other words, whether the marginal product of capital exceeds the cost of capital. In the regard we can express the change in the capital stock as: Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 34
K Where I n I n P [ MPK K ( r )] P (...) is the function showing how net investment responds to the incentives to invest. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 35
We can now write an expression for the investment function: I I n [ MPK P K r P ( )] K Total spending on business fixed investment is the sum of net investment and the replacement for depreciated capital. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 36
The model now shows how investment Relates with the interest rate. A reduction in real interest rate lowers the cost of capital. This increases the profit from owning capital and thus causes capital to increase. By similar reasoning, a rise in the real interest rate raises the cost of capital, reducing profitability and hence causing a decline in capital. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 37
For the reasons stated earlier, the investment function/schedule, relating investment to the interest rate slopes downwards. The model also shows that any event that raises the MPK (improvement in technology increases the profitability of investment and causes the investment schedule to shift outward. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 38
Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 39
Finally we consider what happens when the capital stock is adjusting. 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. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 40
Eventually, as the capital stock adjusts, the marginal product of capital approaches the cost of capital. When the capital stock reaches a steady-state level, we can write: MPK P K P ( r ) Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 41
Thus, in the long run, the marginal product of capital equals the real cost of capital. The speed of adjustment toward the steady state depends on how quickly firms adjust their capital stock, which in turn depends on how costly it is to build, deliver, and install new capital. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 42
Other Determinants of Investment An increase in the size of the economy moves the entire MPK schedule to the right. This rightward shift increases the demand for capital at any given cost of capital (rental cost). This may expressed in the form: * K g( rc, Y ) Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 43
Expected Output But in the expression (reproduced below): * K g( rc, Y ) the level of output must be the level of output at some future period, during which the capital will be in production. For some investments the future time at which output will produced is a matter of weeks or months away, but for others this could be years away. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 44
From this the notion of permanent income is relevant to investment as well. The firm s demand for business fixed capital, which depends on the normal or permanent level of output, thus depends on expectations of future output levels, rather than the current level of output. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 45
Taxes In addition to interest rate and depreciation, the cost of capital is affected by taxes. The two main tax variables are the corporate tax and investment tax policy. A corporate tax is essentially a proportional tax on profit. An investment tax policy may allow firms to deduct from their taxes a fraction of their investment expenditures each year. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 46
Taxes Corporate taxes generally tend to affect the desired stock of capital negatively, such that an increase in the corporate tax rate will adversely impact on investment spending by the firm. On the other hand the investment tax policy reduces the cost of capital, hence this has a positive impact on investment spending by firms. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 47
The Effects of Fiscal and Monetary Policy on the Desired Stock of Capital We have seen that the desired capital stock increases when the expected level of output rises and when the cost of capital falls. The cost of capital falls when the real interest rate and the rate of depreciation fall and when investment tax credits (investment tax policy) rises. An increases in the corporate tax reduces the desired capital stock. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 48
The Effects of Fiscal and Monetary Policy on the Desired Stock of Capital These conclusions imply that monetary and fiscal policy affect the desired capital stock. Fiscal policy exerts an effect through both the corporate tax and investment tax credit. Fiscal policy through its effect on the IS curve, which in turn affect interest rates can affect overall demand for capital. Monetary policy affects capital demand by affecting the market interest rate. Macroeconomics 2 Lecture Material Prepared by Dr. Emmanuel Codjoe 49