Business Firms As Spending Units Investment is defined as ïAïAll spending by business firms for newly built equipment and business structures. ïAïAll changes in business inventories of raw materials, semifinished articles, and finished goods. ïAïAll spending by households for newly constructed residential housing

Why do firms invest-- that is, take positions in long-lived tangible capital goods? Because they expect to gain access to a future income stream by employing the capital to produce goods and services

Let I = f(P k, Q, i), where: P k  Supply price or acquisition cost of capital goods; Q  Expected revenues, net of running expenses, from the sale of output of capital goods;  ¡ is the interest rate.  The marginal efficiency of capital ( r) is the discount rate that makes the capitalized (net) income stream equal to the supply price of the capital good. Thus we have:

P k = $103, (Tractor = $83,077; Trailer = $20,000) n = 3 years Expected revenue from shipping goods (per year) = $168,000 Expected running expenses: Driver salary and benefits $54,000 Diesel fuel 36,000 Repairs (including tires) 16,000 Insurance 11,750 Total $128,000 Thus Q 1 = Q 2 = Q 3 = $40,000

Now solve for r Solution: r = 0.08, meaning that if the prevailing interest rate is above 8 percent, then the present value of the asset is less than its supply price.

 If, for a specific investment project, r > i, then the present value of the asset exceeds its acquisition cost and the investment will be made.  if, however, r < i, then the acquisition cost of the asset will exceed its supply price and the investment will not be made. If r for the project with the highest expected return is 9 percent, but the interest rate is 10 percent, then gross I will be zero. If there is $20 billion in investment with an r of 10 percent or higher, then gross I will be $20 billion.

“Spontaneous urge to action rather than inaction.” “The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible.” (Keynes 1936, p. 147). +Estimates of Q 1, Q 2,..., Q n are subject to revision based on new information or the capricious nature of business confidence. +What looked like a winner yesterday could be a turkey today.

A H B Investment Interest (%) I1I1 I2I2 As r falls, firms can make investments with lesser expected returns  I 1 to I 2 : rising expected profitability of spending for capital goods

i (%) Investment Note that:  Q i, cet. par.  r, and investment shifts to the right Also note:  P K,, cet. par.  r, and function shifts left And vice- versa

0 YDYD I Ia2Ia2 Ia1Ia1 Function could shift down due to: Increase in the interest rate, ceteris paribus. Diminished confidence about the future profitability of investment.