Business investment includes equipment, structures, housing, and inventory. The standard model of business fixed investment examines the marginal product of capital, interest rates, and tax rules. Residential investment depends on housing demand and prices. Inventory investment is small but volatile, and includes materials, work in progress, and finished goods. It aims to smooth production and avoid stock-outs. All components of investment are influenced by the real interest rate.

1. Chapter Eighteen 1
CHAPTER 17
The Theory of Investment
Daw Chan Myae July
14.08.21

2. Chapter Eighteen 2
• Business fixed investment includes the equipment and
structures that businesses buy to use in production.
• Residential investment includes the new housing that
people buy to live in and that landlords buy to rent out.
• Inventory investment includes those goods that businesses
put aside in storage, including materials and supplies, work
in progress, and finished goods.
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3. Chapter Eighteen 3
The standard model of business fixed investment is called the
neoclassical model of investment. It examines the benefits and costs of
owning capital goods. Here are three variables that shift investment:
1) the marginal product of capital
2) the interest rate
3) tax rules
To develop the model, imagine that there are two kinds of firms:
production firms that produce goods and services using the
capital that they rent and rental firms that make all the
investments in the economy.
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4. Chapter Eighteen 4
The real rental price of capital adjusts to equilibrate the demand for
capital and the fixed supply.
MPK = aA(L/K)1-a
R/P = aA(L/K)1-a
K Capital stock, K
Capital demand (MPK)
Capital supply
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•the lower the stock of
capital, the higher the real
rental price of capital
• the greater the amount of
labor employed, the higher
the real rental price of
capitals
• the better the technology,
the higher the real rental
price of capital.

5. Chapter Eighteen 5
For each period of time that a firm rents out a unit of capital, the rental
firm bears three costs:
1) Interest on their loans, which equals the purchase price of a unit of
capital PK times the interest rate, i, so i PK.
2) The cost of the loss or gain on the price of capital denoted as -DPK .
3) Depreciation d defined as the fraction of value lost per period
because of the wear and tear, so d PK .
Therefore the total cost of capital = i PK - DPK + dPK or
= PK (i - D PK/ PK + d)
The real cost of capital—the cost of buying and renting out a unit of
capital measured in terms of the economy’s output is:
The Real Cost of Capital = (PK / P )(r + d), where r is the real interest
rate and PK / P equals the relative price of capital.
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6. Chapter Eighteen 6
For each unit of capital, the firm earns real revenue R/P and bears the
real cost (PK / P)(r + d). The real profit per unit of capital is
Profit rate = Revenue - Cost
= R/P - (PK / P)(r + d)
Because the real rental price equals the marginal product of capital, we
can write the profit rate as
Profit rate = MPK - (PK / P)(r + d)
The change in the capital stock, called net investment depends on the
difference between the MPK and the cost of capital.
If the MPK exceeds the cost of capital, firms will add to their capital
stock.
If the MPK falls short of the cost of capital, they let their capital stock
shrink.
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7. Chapter Eighteen 7
Total spending on business fixed investment is the sum of net
investment and the replacement of depreciated capital.
The investment function is:
I = In [MPK - (PK / P)(r + d)] + dK.
Investment
depends on
marginal product of capital
the cost of capital
amount of depreciation
This model shows why investment depends on the real interest rate.
A decrease in the real interest rate lowers the cost of capital.
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8. Chapter Eighteen 8
Investment, I
Notice that business fixed investment increases when the interest rate
fall—-hence the downward slope of the investment function. Also,
an outward shift in the investment function may be a result of an
increase in the marginal product of capital.
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9. Chapter Eighteen 9
Policymakers often change the rules governing corporate income
tax in an attempt to encourage investment, or at least mitigate the
disincentive the tax provides.
An investment tax credit is a tax provision that reduces a firm’s
taxes by a certain amount for each dollar spent on capital goods.
Because a firm recoups part of its investment in capital goods in the
form of lower taxes, a credit reduces the effective purchase price of
a unit of capital P.
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10. Chapter Eighteen 10
The term stock refers to the shares in the ownership of corporations, and
the stock market is the market in which these shares are traded.
The Nobel-Prize-winning economist James Tobin proposed that firms
base their investment decisions on the following ratio, which is now
called Tobin’s q:
q = Market Value of Installed Capital
Replacement Cost of Installed Capital
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11. Chapter Eighteen 11
The numerator of Tobin’s q is the value of the
economy’s capital as determined by the stock market.
The denominator is the price of capital as if it were
purchased today. Tobin conveyed that net investment
should depend on whether q is greater or less than 1. If
q >1, then firms can raise the value of their stock by
increasing capital, and if q < 1, the stock market values
capital at less than its replacement cost and thus, firms
will not replace their capital stock as it wears out.
Tobin’s q measures the expected future
profitability as well as the current profitability.
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12. Chapter Eighteen 12
We will now consider the determinants of
residential investment by looking at a simple
model of the housing market. Residential
investment includes the purchase of new
housing both by people who plan to live in
it themselves and by landlords who plan to rent
it to others.
There are two parts to the model:
1) the market for the existing stock of houses determines the
equilibrium housing price
2) the housing price determines the flow of residential investment.
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13. Chapter Eighteen 13
Demand
The relative price of housing adjusts to equilibrate supply and demand
for the existing stock of housing capital. The relative price then
determines residential investment, the flow of new housing that
construction firms build.
Stock of housing capital, KH Flow of residential investment, IH
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14. Chapter Eighteen 14
Demand
Stock of housing capital, KH Flow of residential investment, IH
When the demand for housing shifts, the equilibrium price of housing
changes, and this change in turn affects residential investment.
An increase in housing demand, perhaps due to a fall in the interest
rate, raises housing prices and residential investment.
Demand'
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15. Chapter Eighteen 15
Inventory investment, the goods that businesses put aside
in storage, is at the same time negligible and of great
significance. It is one of the smallest components of
spending—but its volatility makes it critical in the study
of economic fluctuations.
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16. Chapter Eighteen 16
When sales are high, the firm produces less that it sells
and it takes the goods out of inventory. This is called
production smoothing. Holding inventory may allow
firms to operate more efficiently. Thus, we can view
inventories as a factor of production. Also, firms don’t
want to run out of goods when sales are unexpectedly
high. This is called stock-out avoidance. Lastly, if a
product is only partially completed, the components are
still counted in inventory, and are called, work in
process.
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17. Chapter Eighteen 17
Like other components of investment, inventory investment depends
on the real interest rate. When a firm holds a good in inventory and
sells it tomorrow rather than selling it today, it gives up the interest it
could have earned between today and tomorrow. Thus, the real
interest rate measures the opportunity cost of holding inventories.
When the interest rate rises, holding inventories becomes more
costly, so rational firms try to reduce their stock. Therefore, an
increase in the real interest rate depresses inventory investment.
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18. Chapter Eighteen 18
•Business fixed
investment
•Residual investment
•Inventory investment
•Depreciation
•Real cost of capital
•Net investment
•Corporate income tax
•Investment tax credit
•Stock
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• Stock market
• Tobin’s q
• Inventories as a factor of
production
• Stock-out avoidance
• Work in process