1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 16 The Economics of Investment Behavior

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-2 The Historical Instability of Investment Recall: Gross Domestic Private Investment (GDPI) includes spending on plant, equipment, inventories, and housing. Historically investment has been more volatile than consumption spending. – In the 1973-75 recession, GDPI fell 31%. – In the subsequent boom, GDPI grew by 46%. – In the 1981-82 recession, fell 26%.

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-3 The Components of GDPI GDPI is divided into two main parts, which also have subcomponents as follows: – Fixed Investment Residential Nonresidential – Nonresidential Structures – Producers’ Durable Equipment – Inventory Change The behavior of the three major components of GDPI is shown in Figure 16-1 and summarized below: – Residential investment turns early. – Inventor change exhibits sharp but short-lived swings. – Fixed nonresidential investment has soared in size.

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-4 Figure 16-1 Real Gross Private Domestic Investment and its Three Components, 1960–2007 Source: Bureau of Economic Analysis, NIPA Tables.

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-5 The Accelerator Hypothesis The Accelerator Hypothesis states that the level of net investment depends on the change in expected output. Firms attempt to maintain a fixed ratio of their stock of capital to their expected sales (Y e ). – Expected sales are assumed to be estimated using adaptive expectations:

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-6 The Accelerator Hypothesis (cont.) The accelerator hypothesis assumes that the desired stock of capital (K * ) is a multiple of expected sales: K * = v * Y e Net investment is the change in the capital stock: I n = ∆K = K – K -1 Assuming that capital is acquired quickly, I n = K * - K * -1  I n = v * ∆Y * When there is an acceleration in business and expected output increases, net investment is positive. – If expect output stops increasing, I n falls to zero.

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-7 Table 16-1 Workings of the Accelerator Hypothesis of Investment for the Hypothetical Mammoth Electric Company

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-8 Figure 16-2 The Behavior of Actual Sales, Expected Sales, Gross Investment, Net Investment, and Replacement Investment for the Mammoth Electric Company Described in Table 16-1

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-9 Investment and Real GDP The relationship between I and GDP is the same as between I n and Y e according to the accelerator hypothesis. – In the special case where expected sales are always set exactly equal to last period’s actual sales: I n = v * ∆Y -1 This simplest form of the accelerator theory was invented by J.M. Clark in 1917. – According to this theory, investment is inherently unstable since any temporary change in output could lead to a significant change in investment spending.

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-10 Assessing the Simple Accelerator There are three main problems with the simple accelerator theory based on historical U.S. data: – I n does not respond instantaneously to changes in output growth, but rather displays noticeable lags. – These lags are not uniform in length, not does I n respond to changes in real GDP growth with uniform speed. – The I n /Y does not have a consistent relationship to real GDP growth. Further, despite the investment boom of the late 1990s, the overall average level of I n /Y was substantially lower than before 1990.

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-11 Figure 16-3 The Relation of the Net Investment Ratio (I n /Y) to the Growth Rate of Real GDP (  Y/Y) in the U.S. Economy, 1960–2007 Source: Bureau of Economic Analysis, NIPA Tables. Details in Appendix C-4.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-12 The Flexible Accelerator The Flexible Accelerator theory of investment loosens several assumptions of the simple accelerator theory: – Instead of assuming Y e = Y -1, the flexible accelerator theory allows for adaptive expectations. – The flexible accelerator theory no longer assumes that v * is constant. – Capital formation is no longer assumed instantaneous. Determinants of gross investment – The fraction of the gap between K * and last period’s actual capital that can be closed in a single period. – The response of Y e to last period’s error in estimating actual output. – The proportion of the capital stock that is replaced each year. – The desired ratio of capital to expected output (v * ).

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-13 The Neoclassical Theory of Investment In the 1960s, Harvard’s Dale Jorgenson showed that the user cost of capital could be derived from neoclassical microeconomic theory. An extra unit of capital will be purchased if the expected Marginal Product of Capital (MPK) is at greater than or equal to the User Cost of Capital (u): MPK ≥ u – MPK is the extra output that a firm can produce by adding an extra unit of capital. – u is the cost to the firm of using a piece of capital for a specified period.

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-14 Policies to Affect u The user cost of capital (u) depends on several factors: – An interest cost is involved in buying a capital good. – Physical deterioration lessens the production ability of every capital good; in addition some capital goods become obsolete. The Depreciation Rate is the annual percentage decline in the value of a capital good due to physical deterioration and obsolescence. – The interest and depreciation cost are adjusted by price changes for capital goods. Monetary and fiscal policies that lower the interest rate will lower u and therefore increase I.

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-15 Figure 16-4 The Effect of a Drop in the User Cost of Capital (u) on the Desired Capital-Output Ratio (v *)

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-16 Taxation and Investment Fiscal policy can also affect the user cost of capital directly via taxes: – A higher tax on firms’ profits will raise the effective user cost of capital for firms. – Firms can cut their corporate income tax by deducting the value of depreciation of plant and equipment, so the government can affect investment by liberalizing or tightening tax laws. – During most of the 1962-86 period, a substantial part of investment in the U.S. was eligible for an investment tax credit. Typically the tax credit would allow firms to deduct 10% of the value of their equipment investment from their corporate income taxes.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-17 Figure 16-5 Change in Real Investment in Computers and Peripherals and in the Computer Deflator, 1988–2007 Source: Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-18 International Perspective: The Level and Variability of Investment Around the World

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-19 Figure 16-6 Effect on Output and the Interest Rate of a Shift in the Level of Investment Relative to the Interest Rate

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-20 Chapter Equations

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-21 Chapter Equations

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-22 Chapter Equations

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16-23 Chapter Equations