Chapter 14: Investment Spending
Summary in Simple Language
1. What is Investment?
In everyday life, we call buying stocks or a house 'investing.' But in macroeconomics,
investment has a specific meaning: it is the money spent to add new physical things to the
economy — like machines, factories, and buildings. Think of it as spending that builds up the
productive tools of the economy.
Investment makes up about 13% of total GDP in the United States. Even though it is a relatively
small share, it swings wildly up and down, which is why it causes a big chunk of the economy's
ups and downs (the business cycle).
2. Why is Investment So Volatile?
Here is a simple way to understand this: imagine a bathtub. The water in the tub = the total
stock of capital (all machines, buildings, etc.). The water flowing in from the tap = investment.
The water draining out = depreciation (wear and tear on old capital).
The key fact is that the tub is HUGE compared to the tap's flow. It would take about 20 years of
investment to fill the capital stock from scratch. So even a tiny change in how much water
people want in the tub causes the tap to either run at full blast or shut off completely. That is
why investment is so volatile — even a small shift in business expectations causes big swings in
investment spending.
A 1% drop in desired capital can cause a nearly 20% drop in annual investment. That is a
massive effect from a small cause!
3. Gross vs. Net Investment
These two terms are important:
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Gross Investment: Gross Investment is the total money spent on new capital, including
replacements for worn-out capital.
• Net Investment: Net Investment is what is left after subtracting depreciation (the
wearing out of old capital). This is what actually grows the economy over time.
Think of it this way: if a factory buys 10 new machines but 3 old ones break down, the gross
investment is 10 machines, but the net addition to the economy is only 7 machines.
Depreciation is not just physical wear and tear. A piece of equipment can become 'economically
obsolete' — for example, an old gas-guzzling machine becomes less valuable when oil prices
rise, even if it still works fine. Computers are a great example of fast economic depreciation
because newer, better models come out constantly.
4. What Determines How Much Businesses Want to Invest?
Businesses want to find the right amount of capital (machines, buildings) to use. They keep
adding capital as long as it earns more than it costs. Two main concepts explain this:
A. Marginal Product of Capital (MPK)
This is the extra output a business gets from using one more unit of capital. As you keep adding
more machines, each extra machine adds a bit less output than the previous one. This is called
diminishing returns. So at some point, adding more capital is no longer worth it.
B. Rental Cost of Capital
This is the cost of using one unit of capital for a period. It includes:
• Interest Rate: The real interest rate (cost of borrowing money, adjusted for inflation)
• Depreciation: Depreciation (how fast the capital wears out)
• Taxes: Taxes (corporate tax increases the cost; investment tax credit reduces it)
A business will keep investing until the gain from the last machine (MPK) equals the cost of
using it (rental cost). If the rental cost rises, businesses want less capital. If expected output
rises, businesses want more capital.
5. Real vs. Nominal Interest Rates
This is a critical distinction. The nominal interest rate is the rate you see quoted at a bank. The
real interest rate adjusts for inflation:
Real Interest Rate = Nominal Interest Rate − Expected Inflation
Example: If a bank charges 10% interest but inflation is also 10%, the real cost of borrowing is
zero. In this case, investment would be very high, even though the nominal rate looks high. This
is why just looking at the nominal interest rate can mislead you.
6. How Do Government Policies Affect Investment?
Monetary Policy
The Federal Reserve (central bank) controls short-term interest rates. When the Fed lowers
interest rates, borrowing becomes cheaper, the rental cost of capital falls, and businesses invest
more. This is the primary way monetary policy impacts investment and the broader economy.
Fiscal Policy — Corporate Tax
A higher corporate income tax reduces profits, making investment less attractive. A lower
corporate tax means businesses keep more of their earnings, so they are more willing to invest.
Fiscal Policy — Investment Tax Credit
This was a policy used in the US (1962–1986) where businesses could deduct a percentage
(e.g., 10%) of their investment from their taxes. So if you invested $1 million, you'd get $100,000
knocked off your tax bill. This directly lowers the rental cost of capital and encourages
investment. A temporary investment tax credit can actually be very powerful — businesses rush
all their planned investments into the year the credit is available.
7. The Stock Market and Investment (Tobin's q)
There is an important connection between the stock market and investment. When a company's
stock price is high, the company can raise a lot of money by selling fewer shares. This makes it
cheaper to finance new investment.
Tobin's q is a ratio that captures this idea:
q = Market Value of Firm ÷ Replacement Cost of Capital
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q > 1: If q > 1: The stock market values the firm's assets more than it costs to build
them. So the firm should invest and build more assets.
• q < 1: If q < 1: It's cheaper to buy existing firms than to build new capital. Investment
slows down.
In short, a booming stock market encourages investment; a falling stock market discourages it.
8. From Desired Capital to Actual Investment — The Flexible
Accelerator
Even when a business knows it wants more capital, it cannot just instantly build it all overnight.
There are limits: shortages of skilled workers, time needed to plan and build, etc. This gives us
the flexible accelerator model.
The idea: businesses close only a fraction of the gap between where they are and where they
want to be, each period. If a business wants 100 machines but only has 80, it won't immediately
buy 20. It might buy 10 this year, then 5 next year, and so on. The fraction they close each
period is called the speed of adjustment.
This is why investment reacts slowly to changes in conditions, and why investment tends to
peak about two years after a change in the demand for capital.
9. Three Types of Investment
A. Business Fixed Investment
This is spending on machinery, equipment, and commercial buildings by businesses. It is the
largest of the three types. It falls sharply in recessions and rises during recoveries. Businesses
rely heavily on retained earnings (profits saved up) to fund investment rather than borrowing,
especially smaller firms.
Credit rationing is an important concept here: even if a business is willing to pay the going
interest rate, banks may refuse to lend if they fear the borrower might default. This makes small
businesses especially vulnerable during downturns.
Some investments are irreversible — once you build a specialized factory, you can't easily
convert it to something else. Because of this, businesses wait until investment is clearly
profitable before committing, rather than investing the moment it barely breaks even.
B. Residential Investment
This is spending on building new homes (both single-family houses and apartment buildings).
Housing is extremely sensitive to interest rates because most people borrow to buy homes
(mortgages). When mortgage rates rise, monthly payments jump significantly, pricing many
buyers out of the market and reducing housing investment.
Even when nominal interest rates are high, the real cost might be low if inflation is also high.
However, high nominal rates still discourage homebuying because buyers have to make large
payments now (even if inflation later reduces the real value of those payments).
Tax rules also matter: in the US, mortgage interest is tax-deductible, which lowers the real aftertax cost of owning a home and encourages housing investment.
C. Inventory Investment
Inventories are goods that businesses hold in storage — raw materials waiting to be used, or
finished products waiting to be sold. Inventory investment is the smallest of the three types but
the most volatile.
Why do businesses hold inventories?
• To meet unexpected demand quickly (you can't manufacture things instantly)
• To order in bulk (cheaper per unit than ordering small amounts frequently)
• To smooth out production (keep production steady even when sales fluctuate)
The accelerator model works well for inventories: inventory investment is roughly proportional to
the change in output. When GDP grows, businesses build up inventories. When GDP falls,
inventories pile up unintentionally, then businesses cut production to run them down.
The key distinction in inventory investment is between intended and unintended:
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Unintended buildup: Unintended inventory buildup = sales fell unexpectedly, so unsold
goods piled up. This is a warning sign of a slowdown.
• Intended buildup: Intended inventory buildup = businesses are stocking up in
anticipation of future demand. This adds to current GDP.
Just-in-time (JIT) inventory management, imported from Japan, has reduced the need for large
inventories by synchronizing production closely with actual demand, helping to reduce economic
volatility.
10. Investment and Long-Run Economic Growth
In the short run, investment has very little effect on the economy's supply capacity — because a
year's investment is only about 1/20 of the total capital stock, a big increase in investment
barely moves the needle on total output within one year.
But over the long run, investment is one of the most powerful drivers of growth. Countries that
invest a high share of their GDP tend to grow faster. High-growth economies like South Korea,
Singapore, and China all had high investment rates (30–40% of GDP) during their rapid growth
periods. Poorer countries with low investment rates tend to remain poor.
The US and Canada have relatively low investment rates compared to their high-growth
competitors, which is a long-term concern for sustained prosperity.
Quick Summary of Key Points
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Definition: Investment = spending that adds to the physical capital stock (not buying
stocks or existing assets).
Size & Volatility: Investment is about 13% of US GDP but drives most of the economy's
volatility.
Desired Capital: The desired capital stock depends on the rental cost of capital and
expected output.
Rental Cost: Rental cost = real interest rate + depreciation (adjusted for taxes).
Policy Tools: Monetary policy affects investment through interest rates; fiscal policy
through taxes and credits.
Stock Market: A high stock market (high q) encourages investment; a low market
discourages it.
Gradual Adjustment: Adjustment is gradual — the flexible accelerator model explains
why investment reacts slowly.
Types of Investment: Three types: Business Fixed (largest), Residential (interest-rate
sensitive), Inventory (most volatile).
Long-run Growth: In the long run, high investment = high growth. In the short run, the
supply effect is tiny.