Lecture Macroeconomics: Lecture 24 - Prof. Dr.Qaisar Abbas

Lecture 24: Investment - I. After studying this chapter you will be able to understand: leading theories to explain each type of investment, why investment is negatively related to the interest rate, things that shift the investment function.

Review of the previous lecture Relative to GDP, the U.S government’s debt is moderate compared to other countries Standard figures on the deficit are imperfect measures of fiscal policy because they – are not corrected for inflation – not account for changes in govt assets – omit some liabilities (e.g future pension payments to current workers) – not account for effects of business cycles Review of the previous lecture In the traditional view, a debt-financed tax cut increases consumption and reduces national saving In a closed economy, this leads to higher interest rates, lower investment, and a lower long-run standard of living In an open economy, it causes an exchange rate appreciation, a fall in net exports (or increase in the trade deficit) The Ricardian view holds that debt-financed tax cuts not affect consumption or national saving, and therefore not affect interest rates, investment, or net exports Review of the previous lecture Most economists oppose a strict balanced budget rule, as it would hinder the use of fiscal policy to stabilize output, smooth taxes, or redistribute the tax burden across generations Government debt can have other effects: – may lead to inflation – politicians can shift burden of taxes from current to future generations – may reduce country’s political clout in international affairs or scare foreign investors into pulling their capital out of the country Lecture 24 Investment - I Instructor: Prof Dr Qaisar Abbas Lecture Contents • leading theories to explain each type of investment • why investment is negatively related to the interest rate • things that shift the investment function 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 U.S Investment and its components, 1970-2002 2000 Billions of 1996 dollars 1750 PT PT PT P T P 1500 1250 1000 750 500 250 -250 1970 1975 1980 1985 1990 1995 2000 Total Business fixed investment Residential investment Change in inventories slide 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 Two types of firms For simplicity, assume two types of firms: Production firms rent the capital they use to produce goods and services Rental firms own capital, rent it out to production firms In this context,  “investment” is the rental firms’  spending on new capital goods The capital rental market • • Production firms must decide how much capital to rent real rental price, R/P capital supply Recall from chap 3: Competitive firms rent capital to the point where MPK = R/P capital demand (MPK) equilibrium rental rate K K capital stock Factors that affect the rental price For the Cobb-Douglas production function, Y = AK α L1−α the MPK (and hence  R = MPK = α A ( L K equilibrium R/P ) is P ) 1−α The equilibrium R/P  would increase if: • K  (due, e.g., to earthquake or war) • L  (due, e.g., to pop. growth or immigration) • A  (technological improvement, or deregulation) 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 out to production firms 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: The cost of capital Nominal  cost  of capital � ∆PK � i +δ − = i PK + δ PK − ∆PK = PK � � PK � � Example car rental company (capital: cars) Suppose PK = $10,000, i = 0.10, = 0.20, and PK/PK = 0.06 Then,  interest cost =             depreciation cost =  $1000 $2000  $600 $2400 The cost of capital For simplicity, assume PK/PK = Then, the nominal cost of capital equals PK(i + ) = PK(r + ) and the real cost of capital equals PK (r +δ) P The real cost of capital depends positively on: • the relative price of capital • the real interest rate • the depreciation rate The rental firm’s profit rate Firm’s net investment depends on the profit rate: PK PK R Profit rate = − ( r + δ ) = MPK − ( r + δ ) P P P § If profit rate > 0,  then it’s profitable for firm to increase K  § If profit rate