Investment
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Investment
Financial vs physical capital
• In the consumption-saving model studied earlier, we studied the role of
financial capital and investment.
• Financial capital consists of IOUs like stocks, bonds, and money.
• Financial capital may facilitate production of final goods and services, but
does not directly produce output.
• In contrast, physical/human capital serves as an input in the production
process.
• Think of physical capital as an intertemporal production technology.
Investment
• Investment refers to newly produced capital goods.
— machinery, inventory, homes, office buildings, roads, sewers, maintenance and repair.
• NIPA only records investment in non-human forms of capital.
— in reality, human capital investment is hugely important.
• But physical capital is obviously important too (just look around you).
• Most of the business cycle is accounted for by swings in investment.
Intertemporal production
• How might Robinson Crusoe transport coconuts today into the future?
• In the consumption-saving model, RC transported his private consumption
into the future at the expense of his debtor’s consumption—no additional
output was produced.
• But suppose RC can physically transport his coconuts to the future?
— e.g., by planting a coconut or holding it as inventory.
— this can be done even independently of financial markets.
The investment demand function
• Suppose that units of investment today yields an expected output ()
• () is an increasing and strictly concave function, 0() 0 00() 0
• is an expected productivity parameter.
• 0() is the expected marginal product of investment (future capital).
— an increasing function of and a decreasing function of
The investment demand function
• Let denote the gross real rate of interest.
• Expected net present value (NPV) of capital spending is given by
(
()
() = − +
)
• The investment demand function ( ) maximizes () i.e., 0() =
0 or
0() =
• is a decreasing function of and an increasing function of
Stock market value
• Define ∗( ) ≡ (( ))
• Can interpret ∗ as the value of business sector capital (corporate stocks
and bonds).
• ∗ is a decreasing function of and an increasing function of
• Re: increase in = “good news” and decrease in = “bad news.”
• Good news leads to boom in desired capital spending and stock market
values.
Investment and saving
• Earlier, we studied the consumption-saving choice of Robinson Crusoe assuming only financial capital.
• Suppose now that RC can invest in domestic capital .
• GDP flow is now given by {1 2} = { ()}
• Consumption-saving decision is solution to
2
max (1 2) subject to 1 +
≤ + ∗( )
Investment and saving
• Solution implies a desired domestic saving function ( )
• is increasing in increasing in and decreasing in
— note: an increase in and elicits a weaker response in desired saving
than changes in or individually (why?).
• Recall ≡ + + + and ≡ − − implies ≡ +
• In our model, = ( ) − ( )
Closed economy
• In a closed economy, = 0 so that saving must equal investment
( ) = ( )
• One can think of equation above as defining an “IS curve”—combinations
of ( ) that are consistent with =
• Alternatively, one can think of IS curve as representing the aggregate demand for output as a function of and
• This framework can accommodate many different views of the business
cycle.
Classical view
• Level of is determined in labor market, largely independent of and
• In this case, (∗ ) = (∗ ) determines the equilibrium interest
rate ∗
• Fluctuations in reflect rational changes in expectations, inducing cyclical
fluctuation in capital spending, stock market valuations, and interest rates.
• No obvious role for government stabilization policies.
Keynesian view
• Level of is determined by aggregate demand, a function of and
• In this case, ( ∗ ) = ( ) determines equilibrium level of ∗
• But ∗ may be either too high or too low because market expectations
can be overly optimistic or pessimistic (animal spirits).
• Stabilization policies are desirable, e.g., lower (add stimulus) if overly
pessimistic decline in .
