In this text you can find some answers leading theories to explain each type of investment. Why investment is negatively related to the interest rate; Things that shift the investment function; And why investment rises during booms and falls during recessions.

Three types of investment:

  1. Business fixed investment: businesses’ spending on equipment and structures (furniture, computers…) for use in production.
  2. Residential investment: purchases of new housing units (either by occupants or landlords).
  3. Inventory investment: the value of the change in inventories of finished goods, materials and supplies, and work in progress.

Understanding business fixed investment:

The standard model of business fixed investment: the neoclassical model of investment. This model shows how investment depends on:

  1. MPK (marginal product of capital) -> marginal derivative of output with respect of capital
  2. Interest rate (if high, we will have low investment & if low interest rate, we will have a higher investment)
  3. Tax rules affecting firms

For simplicity, we assume two types of firms:

1. Production firms rent the capital they use to produce goods and services. employed workers, land capital

2. Rental firms own capital, and they rent it out to production firms.

So, let’s look at the capital rental market:

How many machines do I need to rent?



the capital rental market










R/P = Real rental price


The more capital you have, the return is diminishing.

Factors that affect the rental price









Rental firms’ investment decisions

1. Rental firms invest in new capital when the benefit of doing so exceeds the cost.
2. The benefit (per unit capital): R/P, the income that rental firms earn fromrenting the unit of capital to production firms.

the cost of capital









If you have a capital gain, it is a good thing as it will reduce capital.


the reantal firs profit rate









net investment










the investment function










An increase in MPK or decrease in PK/P will increases the profit rate, it will increases investment at any given interest rate and shifts I curve to the right.

Two of the most important taxes affecting investment:
1.Corporate income tax
2.Investment tax credit

1. Corporate Income Tax: A tax on profits
Impact on investment depends on definition of “profit.” In our definition (rental price minus cost of capital), depreciation cost is measured using current price of capital, and the CIT would not affect investment But, the legal definition uses the historical price of capital. If PK rises 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 zero. Thus, corporate income tax discourages investment.


2. The Investment Tax Credit (ITC)
The ITC reduces a firm’s taxes by a certain amount for each dollar it spends on capital. Hence, the ITC effectively reduces PK
which increases the profit rate and the incentive to invest.


tobins q











relation between q theory and meoclassical theory










The stock market and GDP:
Reasons for a relationship between the stock market and GDP:
1. A wave of pessimism about future profitability of capital would:
– cause stock prices to fall
– cause Tobin’s q to fall
– shift the investment function down
– cause a negative aggregate demand shock

2. A fall in stock prices would:
– reduce household wealth
– shift the consumption function down
– cause a negative aggregate demand shock

3. A fall in stock prices might reflect bad news about technological progress and long-run economic growth.

This implies that aggregate supply and full-employment output will be expanding more slowly than people had expected.


Alternative views of the stock market: The Efficient Markets Hypothesis:

1. Efficient Markets Hypothesis (EMH):

The market price of a company’s stock is the fully rational valuation of the company, given current information about the company’s business prospects.
– Stock market is informationally efficient: each stock price reflects all available information about the stock.
– Implies that stock prices should follow a random walk (be unpredictable), and should only change as new information arrives.


2. Keynes’s “beauty contest”:
– Idea based on newspaper beauty contest in which a reader wins a prize if he/she picks the women most frequently selected by other readers as most beautiful.
– Keynes proposed that stock prices reflect people’s views about what other people think will happen to stock prices; the best investors could outguess mass psychology.
– Keynes believed stock prices reflect irrational waves of pessimism/optimism (“animal spirits”).


Both views persist.
There is evidence for the EMH and random-walk theory (see p.508).
Yet, some stock market movements do not seem to rationally reflect new information.


Financing constraints:
– Neoclassical theory assumes firms can borrow to buy capital whenever doing so is profitable.
– But some firms face financing constraints: limits on the amounts they can borrow (or otherwise raise in financial markets).
– A recession reduces current profits. If future profits expected to be high, investment might be worthwhile. But if firm faces financing constraints and current profits are low, firm might be unable to obtain funds.


Residential investment
The flow of new residential investment, IH , depends on the relative price of housing PH /P.
PH /P determined by supply and demand in the market for existing houses.


how residential investment is determined











how residential investment responds to a fall in interests rates











Inventory investment is only about 1% of GDP.
Yet, in the typical recession, more than half of the fall in spending is due to a fall in inventory investment.

Motives for holding inventories:
1. production smoothing
Sales fluctuate, but many firms find it cheaper to produce at a steady rate.
– When sales < production, inventories rise.
– When sales > production, inventories fall.


2. inventories as a factor of production
Inventories allow some firms to operate more efficiently.
– samples for retail sales purposes
– spare parts for when machines break down


3. stock-out avoidance
To prevent lost sales when demand is higher than expected.


4. work in process
Goods not yet completed are counted in inventory.


Inventories, the real interest rate, and credit conditions:
Inventories and the real interest rate:
– The real interest rate is the opportunity cost of holding inventory (instead of, e.g., bonds)
Example: High interest rates in the 1980s motivated many firms to adopt just-in-time production, which is designed to reduce inventories.
Inventories and credit conditions:
– Many firms purchase inventories using credit.
Example: The credit crunch of 2008-09 helped cause a huge drop in inventory investment..

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