Investment, again: ûAll spending by firms for newly built equipment and durable structures ûAll changes in business inventories ûAll spending by households for newly constructed residential housing The record shows that I is volatile--showing substantial variation from month to month or year to year.

 Investment is assumed to be an autonomous variable in our model. That is, I is presumed to be determined independent of current real output and income. More precisely, we can say that: I = f(r,  ), where r is the interest rate; and  is expected profits from spending for tangible, capital goods r I I function shifts right due to increase in , ceteris paribus I1I1 I2I I0I0

3 Acquisition price of tractor trailer rig (known) $100,000 3 Expected revenue per year from shipping goods 168,000 Expected running expenses per year $128,000 Driver salary and benefits $54,000 Diesel fuel 36,000 Insurance 11,750 Repairs, other 26,250

Let R denote expected revenue per year C is expected cost per year AC is the acquisition price of the capital good. Thus we have: Ignoring taxes, if the interest rate is less than 40 percent, the investment will be made

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

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.

 Assume that r = 9% and the investment demand schedule is in position I 1

For a closed economy without a public sector: Y  C + I [1] C =C a + cY D [2] I = I a [3] Since there is no public sector nor retained earnings, we can say: Y = Y D. Therefore, [2] can be rewritten as: C = C a + cY [4] Substitute [4] and [3] into [1]: Y = C a + cY + I a [5]

C =C a + cY AE = C a + I a + cY AE = Y AE Y C a + I a c Y*Y* In equilibrium, AE = Y and unplanned inventory investment is zero There is no guarantee that Y * will correspond to potential GDP 0

Y  C + I C = Y D I = 60 Thus: Y* = Y* = 90/.30 = AE Y 300 AE = Y AE C 

Properties of Equilibrium in the Keynesian System b Planned spending (AE) is equal to real output (Y) so that firms on average experience zero unplanned inventory accumulation or de-accumulation. b Firms on average have no reason to expand or contract their output level; nor do they have any incentive to offer more or less employment. b Equilibrium GDP might be equal to potential or full employment GDP (the “special” or “Classical” case], but there is no guarantee (as is true for the Classical model). The more likely outcome (or what Keynes referred to as the “general case” ) is “underemployment equilibrium.”

Y AE AE = Y AE When Y = $200 AE > Y by $30 UI = ($30) Firms have an incentive to expand output and employment UI is unplanned inventory investment When Y = $400 AE < Y by $30 UI = $30 Firms have an incentive to decrease output and employment UI