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MACROECONOMICSMACROECONOMICS
2010 Worth Publishers, all rights reserved 2010 Worth Publishers, all rights reserved
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PowerPointPowerPointSlides by Ron CronovichSlides by Ron Cronovich
N. Greory !"n#iwN. Greory !"n#iw
C H $ P T EC H $ P T E
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Invest%entInvest%ent
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Modified for EC 204by Bob Murphy
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In this chapter, you will learn:In this chapter, you will learn:
leading theories to explain each type ofinvestment
why investment is negatively related to the
interest rate things that shift the investment function
why investment rises during booms and falls
during recessions
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3CHAPTER 18 nvestment
Three types of investment
Business fixed investment!businesses" spending on e#uipment 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 wor( in progress$
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!S! Investment an" its components,#$%&'(&&$
Billionsof 200)
dollars
Total investmentBusiness fixed investment
Residential investment
Change in inventories
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)CHAPTER 18 nvestment
n"erstan"in) *usiness +e"
investment
*he standard model of business fixedinvestment!
the neoclassical model of investment
+hows how investment depends on! MPK
interest rate
tax rules affecting firms
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,CHAPTER 18 nvestment
Two types of +rms
-or simplicity' assume two types of firms!
.$ Production firms rent the capital they use
to produce goods and services$
2$ Rental firms own capital' rent it toproduction firms$
In this context,investment is the rental firms
sending on ne! caital goods"
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The capital rental mar-et
roduction firms
must decide how
much capital to rent$
1ecall from Chap$ 3!Competitive firms
rent capital to the
point where
MPK R#P$(
capitalstoc(
real rentalprice' R)P capital
supply
capitaldemand%MPK&
e$uili%riumrental rate
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.actors that a/ect the rental price
-or the Cobb5ouglasproduction function'
the MPK%and hence
e#uilibrium R#P & is
*he e#uilibrium R#P would increase if!
K &e"g", earth$ua'e or !ar(
L &e"g", o" gro!th or immigration(
A &technological imrovement, or deregulation(
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6CHAPTER 18 nvestment
Rental +rms0 investment "ecisions
1ental firms invest in new capital when thebenefit of doing so exceeds the cost$
*he benefit %per unit capital&!
R/P' the income that rental firms earnfrom renting the unit of capital to
production firms$
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.0CHAPTER 18 nvestment
The cost of capital
Components of the cost of capital!
interest cost) iPK'
where PK nominal price of capital
dereciation cost) PK'
where rate of depreciation
caital loss) PK
%a capital gain' PK7 0' reduces cost of K &
*he total cost of capital is the sum of these
three parts!
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..CHAPTER 18 nvestment
*hen' interest cost
depreciation cost
capital loss
total cost
The cost of capital
Example: car rental company %capital! cars&
+uppose PK 8.0'000' i 0$.0' 0$20'and PK9PK 0$0,
:ominal costof capital
8.000
82000
8,00
82400
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.2CHAPTER 18 nvestment
The cost of capital
-or simplicity' assume PK9PK $
*hen' the nominal cost of capital e#uals
PK%i ; & PK%r;&
and the real cost of capital e#uals
*he real cost of capital depends positively on!
the relative price of capital
the real interest rate
the depreciation rate
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.3CHAPTER 18 nvestment
The rental +rm0s pro+t rate
< firm"s net investment depends on its profit rate!
f profit rate 7 0'then increasing K is profitable
f profit rate = 0' then the firm increases profits by
reducing its capital stoc(%i"e"' not replacing capital as it depreciates&
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.4CHAPTER 18 nvestment
Net investment 1 )ross investment
>ence'
where In* + is a function that shows hownet investment responds to the incentive to invest$
*otal spending on business fixed investment e#uals
net investment plus replacement of depreciated K!
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.)CHAPTER 18 nvestment
The investment function
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.,CHAPTER 18 nvestment
The investment function
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./CHAPTER 18 nvestment
Taes an" investment
*wo of the most important taxes
affecting investment!
.$ Corporate income tax2$ nvestment tax credit
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.CHAPTER 18 nvestment
Corporate Income Ta: A ta on
pro+tsmpact on investment depends on definition of ?profit$@
n our definition %rental price minus cost of capital&'
depreciation cost is measured using current price
of capital' and the C* would not affect investment
But' the legal definition uses the historical price ofcapital$
f PKrises over time' then the legal definition
understates the true cost and overstates profit'
so firms could be taxed even if their true economic
profit is Aero$
*hus' corporate income tax discourages investment$
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.6CHAPTER 18 nvestment
The Investment Ta Cre"it 2ITC3
*he *C reduces a firm"s taxes by a certainamount for each dollar it spends on capital$
>ence' the *C effectively reduces PK
which increases the profit rate and the incentiveto invest$
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20CHAPTER 18 nvestment
To*in0s 4
numerator! the stoc( mar(et value of the
economy"s capital stoc($ denominator! the actual cost to replace the capital
goods that were purchased when the stoc( was
issued$
f q 7 .' firms buy more capital to raise the mar(et
value of their firms$
f q = .' firms do not replace capital as it wears out$
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2.CHAPTER 18 nvestment
Relation *etween 4 theory an"
neoclassical theory "escri*e" a*ove
*he stoc( mar(et value of capital depends on the
current expected future profits of capital$ f MPK7 cost of capital' then profit rate is high'
which drives up the stoc( mar(et value of the firms'
which implies a high value of q$
f MPK= cost of capital' then firms are incurring
losses' so their stoc( mar(et values fall' so qis low$
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22CHAPTER 18 nvestment
The stoc- mar-et an" 567
Reasons for a relationshi %et!een thestoc' mar'et and *+P)
.$< wave of pessimism about future
profitability of capital would! cause stoc( prices to fall
cause *obin"s $ to fall shift the investment function down cause a negative aggregate demand shoc(
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23CHAPTER 18 nvestment
The stoc- mar-et an" 567
Reasons for a relationshi %et!een thestoc' mar'et and *+P)
2$< fall in stoc( prices would!
reduce household wealth shift the consumption function down
cause a negative aggregate demand shoc(
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24CHAPTER 18 nvestment
The stoc- mar-et an" 567
Reasons for a relationshi %et!een thestoc' mar'et and *+P)
3$< fall in stoc( prices might reflect bad news
about technological progress and longruneconomic growth$
*his implies that aggregate supply and full
employment output will be expanding moreslowly than people had expected$
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The stoc- mar-et an" 567
ercentchange
from. year
earlier
ercentchangefrom. yearearlier
Real *+P &right scale(
toc' rices &left scale(
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2,CHAPTER 18 nvestment
Alternative views of the stoc- mar-et:
The E8cient Mar-ets 9ypothesis
Efficient ar!ets Hypot"esis #EH$%*he mar(et price of a company"s stoc( is the fullyrational valuation of the company'given current information about the company"s
business prospects$
+toc( mar(et is informationally efficient!each stoc( price reflects all available information
about the stoc($ mplies that stoc( prices should follow a random
&al!%be unpredictable&' and should only changeas new information arrives$
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2/CHAPTER 18 nvestment
Alternative views of the stoc- mar-et:
eynes0s ;*eauty contestigh interest rates in the .60s
motivated many firms to adopt Iustintimeproduction' which is designed to reduceinventories$
nventories and credit conditions
Many firms purchase inventories using credit$
Example! *he credit crunch of 20006 helpedcause a huge drop in inventory investment$$
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Chapter SummaryChapter Summary
.$
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Chapter SummaryChapter Summary
3$ nvestment is the most volatile component ofG5 over the business cycle$
-luctuations in employment affect the M and
the incentive for business fixed investment$
-luctuations in income affect demand for' priceof housing and the incentive for residentialinvestment$
-luctuations in output affect planned unplanned inventory investment$