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MACROECONOMICS:
THEORY AND POLICY
Anindya S. Chakrabarti
Indian Institute of Management, Ahmedabad
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Recap
• Discussed consumption.

• Discussed some theories of consumption.

• Keynesian theory of consumption.

• Life-cycle hypothesis.

• Modern theory is based on permanent income hypothesis.

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Investment Spending
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Introduction
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Introduction
• Investment:
 Links the present to the future
 Links the goods and money markets
 Drives much of the business cycle

• In this chapter we study how investment depends on

interest rates and income

• The figure in the last slide, illustrates the volatility of

investment by comparing investment and GDP
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Introduction
• The theory of investment is the theory of the demand for
capital

• Investment is the flow of spending that adds to the stock of capital

• Both GDP and investment are flow variables

• Capital is the dollar value of all the buildings, machines, and

inventories at a given point in time  stock value

• Investment is the amount spent by businesses to add to the existing

capital stock over a given period
Flow of investment is quite small compared to the stock of capital.
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The Desired Capital Stock

• Firms use capital, along with labor and other resources, to
produce output  The goal of a given firm is to maximize
profits

When deciding the optimal level of capital, firms must balance the
contribution that more capital makes to their revenues against the
cost of acquiring additional capital

The marginal product of capital is the increase in output produced by using

1 more unit of capital in production.

The rental (user) cost of capital is the cost of using 1 more unit of capital in production.
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Interest rate
• Interest rate = rate of payment on a loan or other
investment over and above the principle repayment in
terms of an annual percentage
• Cost of borrowing money OR benefit of lending money

• Nominal interest rate = return on an investment in current

Rupees

• Real interest rate = return on an investment, adjusted for

inflation

• If R is the nominal rate, and r is the real rate, then we can

define the nominal rate as: R  r 
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The Desired Capital Stock

• To derive the rental cost of capital:

• firms finance the purchase of capital by borrowing over time, at an

interest rate of i

• In the presence of inflation, the nominal Rupee value of capital

rises over time

• Real cost of capital = nominal interest rate - nominal capital gain

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The Desired Capital Stock

• To derive the rental cost of capital:
• Real cost of capital = nominal interest rate - nominal capital gain

• At the time the firm makes an investment, the nominal interest rate
is known, but the inflation rate for the coming year is not

• Real cost of borrowing is the expected real interest rate:

r  i  e
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The Desired Capital Stock

• To derive the rental cost of capital:
• Real cost of capital = nominal interest rate - nominal capital gain

• Capital wears out over time  must include depreciation, d

• The complete formula for the rental cost of capital is:

rc  r  d  i   e  d
The Desired Stock of Capital
• Firms add capital until the
marginal return of the last [Insert Figure 14-2 here]
unit added drops to the
rental cost of capital

• Diminishing marginal product of

capital means that each
successive unit of capital yields
less than the previous unit

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The Desired Stock of Capital
• An increase in the rental cost of
capital can only be justified by
an increase in the marginal [Insert Figure 14-2 here]
product of capital, and a lower
level of K

• The general relationship

among the desired capital
stock, K*, rc, and output is

K  g ( rc, Y )
*

14-13
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Capital Stock Adjustment

• The flexible accelerator model can be used to explain the
speed at which firms plan to adjust their capital stock

 Basic notion: the larger the gap between the existing capital stock
and the desired capital stock, the more rapid a firm’s rate of
investment
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Capital Stock Adjustment

• The flexible accelerator model can be used to explain the
speed at which firms plan to adjust their capital stock

 Firms plan to close a fraction, , of the gap between the actual and
desired capital stocks each period
• Capital at the end of last period is K-1
• The gap between actual and desired capital stock is (K*-K-1)
• A firm plans to add a fraction of the gap to last periods stock
• Actual capital stock at the end of the current period is then

K 0  K 1   ( K *  K 1 )
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Capital Stock Adjustment

• To increase the capital stock from K-1 to K0, the firm must
achieve net investment of

I  ( K0  K 1 )
 ( K 1   ( K  K 1 ))  K 1
*

  ( K  K 1 )
*
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Capital Stock Adjustment

[Insert Figure 14-5 here]
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Capital Stock Adjustment

• To increase the capital stock from K-1 to K0, the firm must
achieve net investment of
I  ( K 0  K 1 )
 ( K 1   ( K *  K 1 ))  K 1
  ( K *  K 1 )

• Shows investment spending as a function of K* and K-1

• Any factor that increases K*, increases the rate of investment

• Investment contains aspects of dynamic behavior

Investment Subsectors
• The volatility of the three [Insert Figure 14-6 here]
investment subsectors:
1. Business fixed investment
2. Residential investment
3. Inventory investment

 Business fixed investment is

the largest of the three
 Inventory investment is the
most volatile

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Investment Subsectors
• Inventories include raw [Insert Figure 14-8 here]
materials, goods in the
production process, and
completed goods held by
firms in the anticipation of
the products’ sale
• The ratio of manufacturing
inventories to sales over
time
• Until 1990, ratio on range of 13
to 17 percent
• Since then has fallen to close to
10 percent (just-in-time
manufacturing techniques)
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Investment Subsectors
• Firms hold inventories for several reasons:

 To meet future demand for goods, because goods cannot be

instantly manufactured or obtained to meet demand

 It is less costly for a firm to order goods less frequently in large

quantities than to order more frequently in small quantities

 A way for producers to smooth production and produce at a

constant rate
 Inventories increase when demand falls and decrease when demand
increases

 An unavoidable part of the production process