Chapter 12 Investment Spending

Fixed investment: the neoclassical approach Fixed investment is the most volatile component of GDP.

Fixed investment: the neoclassical approach The desired capital stock: K * =g(rc, Y e )

Fixed investment: the neoclassical approach The rental cost and real interest rate:  rc=r+d;  r=i-  e ;  rc=i-  e +d. Taxes and the rental cost of capital:  Corporate tax does not affect the trade-offs between MPK and rental cost;  The problem:

Fixed investment: the neoclassical approach The stock market and the cost of capital  Investment financed by undistributed profits;  Tobin’s average q: Q=V/PK;  Firms invest until the marginal value of capital equals marginal replacement cost;  The investment function: I/K=h(Q) h(1)=0, h>0.  Booming stock market stimulates investment;  Corporate income tax lowers Q and discourages investment.

Fixed investment: the neoclassical approach The effects of fiscal and monetary policy on the desired capital stock:  Increase in the expected Y: I increases;  Decrease in rc: I increases; Decrease in r, d, or increase in ITC.  Decrease in corporate profit tax t: I increases;  Fiscal policy: t, ITC, r (through IS curve);  Monetary policy: r and Q.

Fixed investment: the neoclassical approach Capital stock adjustment:  The old view: firms adjust to desired level of capital instantly;  Modern theory: extra investment costs, investment are made gradually. I= (K * -K -1 )

Fixed investment: the neoclassical approach The timing of investment and investment tax credit:  Announced ITC in the future: delay investment until ITC implemented;  Temporary ITC: Squeeze investment into the period when ITC is effective;  Temporary shifts in the tax scheme may have a stronger effect on investment.

Business fixed investment: alternative approaches Present value of marginal investment: Cost of marginal investment: c; Carry out the investment if v>c; Implication: higher interest rate lowers current value and discourages investment; Conceptually similar to previous theory.

Business fixed investment: alternative approaches The accelerator model:  K=kY;  I=  K=k  Y;  Investment is proportional to output growth.