CHAPTER 14•INVESTMENT SPENDING 359

shows the corresponding flow of investment. The assumed speed of adjustment is

 .5.
Starting from K−1, one-half the gap between target capital and current actual capi-
tal is made up in every period. First-period net investment is therefore .5(K* − K−1). In
the second period, investment will be one-half the previous period’s rate, since the gap
has been reduced by half. Investment continues until the actual capital stock reaches the
level of target capital. The larger is, the faster the gap is reduced.
In equation (3), we have reached our goal of deriving an investment function that
shows current investment spending determined by the desired stock of capital, K*, and
the actual stock of capital, K−1. Any factor that increases the desired capital stock
increases the rate of investment. Therefore, an increase in expected output, a reduction
in the real interest rate, or an increase in the investment tax credit will each increase the
rate of investment. The flexible accelerator demonstrates that investment contains as-
pects of dynamic behavior—that is, behavior that depends on values of economic vari-
ables in periods other than the current period. Empirical evidence shows that the
dynamics of the flexible accelerator are somewhat too rigid—for example, investment
takes about two years to peak after a change in capital demand—but the basic principle
of gradual adjustment is clear.

14-2
INVESTMENT SUBSECTORS—BUSINESS FIXED,
RESIDENTIAL, AND INVENTORY
Figure 14-6 demonstrates the volatility of each of the three investment subsectors: busi-
ness fixed investment, residential investment, and inventory investment. Fluctuations are
on the order of several percent of GDP. Business fixed investment is the largest of the
three, but all three subsectors undergo swings that are substantial fractions of swings in
GDP. Inventory investment is considerably smaller than the other two portions, but as
you can see, it is particularly volatile.

BUSINESS FIXED INVESTMENT

Figure 14-6 shows fixed investment as a share of GDP. In a recession or shortly before,
the share of investment in GDP falls sharply; then investment begins to rise as the
recovery gets under way. The cyclical relationships extend much further back in history.
For instance, gross investment fell to less than 4 percent of GDP in the Great Depres-
sion years 1932 and 1933.

The Timing of Investment

Credit Rationing and Internal Sources of Finance Table 14-1 shows the sources of
manufacturing firms’ funding in the United States during the period 1970–1984. The
predominance of retained earnings as a source of financing stands out. Firms of all sizes

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 360 PART 4•BEHAVIORAL FOUNDATIONS

14

Investment as a percent of GDP

Business fixed
12
10
8
6 Residential
4
2 Inventory
0
–2
–4
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

FIGURE 14-6 COMPONENTS OF INVESTMENT AS A PERCENTAGE OF GDP, 1959–2010.

The three different types of investment are shown: residential investment, business fixed
investment, and inventory investment. The latter is very small and sometimes negative, but
it is also relatively very volatile. (Source: Bureau of Economic Analysis.)

use outside funding from banks, bond markets, and equity only to a limited extent.7
Instead, they rely on retained earnings, profits that they do not pay out to stockholders,
to finance investment. As the last column of the table shows, retained earnings exceeds
50 percent of earnings for all firms and is relatively most important for the smallest
firms.
What do these facts mean for the investment decision? They suggest that there is a
close link between the earnings of firms and their investment decisions. If firms cannot
readily obtain funding from outside sources when they need it, the amount of assets they
have on hand will affect their ability to invest. This would mean that the state of a firm’s
balance sheet, and not just the cost of capital, is a financial determinant of investment
decisions.
Box 14-6 describes the important phenomenon of credit rationing, which occurs
when individuals cannot borrow even though they are willing to do so at the existing
interest rates. There are good reasons for credit rationing, all stemming from the risk
that the borrower will not repay the lender, for instance, because the borrower goes
bankrupt. These arguments suggest that credit rationing is more likely for small firms
without an established reputation than for large firms with a track record. The fact that
the retention ratio in Table 14-1 declines with firm size is consistent with this implica-
tion. These data, as well as the experience of firms that want to borrow, are consistent
with the assumption that firms are rationed in their access to funding.8

7
Equity funding is excluded from the table, but independent evidence, noted in the article by Fazzari, Hubbard,
and Petersen (cited in Table 14-1) shows that it provides very little financing for firms, especially small ones.
8
See Stephen D. Oliner and Glenn D. Rudebusch, “Is There a Broad Credit Channel for Monetary Policy?”
Federal Reserve Bank of San Francisco Economic Review 1 (1996), for evidence showing that internal
sources of funds are especially important for small firms and especially important in downturns.

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 CHAPTER 14•INVESTMENT SPENDING 361

TABLE 14-1 Sources of Funds, U.S. Manufacturing Firms, 1970–1984

SOURCE OF FUNDS, % OF TOTAL*
PERCENT
OTHER OF LONG-
SHORT- LONG- LONG- TERM
TERM TERM TERM DEBT AVERAGE
BANK BANK BANK RETAINED FROM RETENTION
FIRM SIZE DEBT DEBT DEBT EARNINGS BANKS RATIO, %
All firms 0.6 8.4 19.0 71.1 29.6 60
Asset class
Under $10 million 5.1 12.8 6.2 75.9 67.3 79
Over $1 billion −0.6 4.8 27.9 67.9 14.7 52

*Minus sign indicates that firms have net assets (rather than liabilities) in this category.
Source: Steven M. Fazzari, R. Glenn Hubbard, and Bruce C. Petersen, “Financing Constraints and Corporate Investment,”
Brookings Papers on Economic Activity 1 (1988).

Under such conditions, firms’ investment decisions will be affected not only by the
interest rate but also by the amount of funds the firms have saved out of past earnings
and by their current profits. The cost of capital must still affect the investment decision,
because firms that retain earnings have to consider the alternative of holding financial
assets and earning interest rather than investing in plant and equipment. There is indeed
evidence that the rate of investment is affected by the volume of retained earnings and
by profits, as well as by the cost of capital.
In the early 1990s, in the aftermath of severe banking problems due to losses in
real estate, credit rationing was held responsible for the slow—despite low short-term
interest rates—rate of investment in the United States. Banks were lending very little,
especially to small- and medium-size firms. The problem was especially severe in de-
pressed regions, because small businesses can only borrow locally, from banks, but
banks in a depressed region are especially unwilling to lend.
Irreversibility and the Timing of Investment Decisions Beneath the stock-demand-
for-capital-leads-to-investment-flow model lies the idea that capital is “putty-putty.”
Goods are in a malleable form that can be transformed into capital by investment and
then easily transformed back into general goods. Much capital is better described as
“putty-clay.” Once capital is built, it can’t be used for much except its original purpose.
A warehouse (putty-putty) may have high-valued alternative uses as a factory or an
office building. A jetliner (putty-clay) isn’t of much use except for flying. The essence
of putty-clay investment is that it is irreversible. An irreversible investment will be
executed not when it becomes merely profitable but, rather, when it does not pay to wait
for any further improvement in profitability.9
9
This statement is based on a sophisticated argument in terms of financial option theory. See Robert Pindyck,
“Irreversible Investment, Capacity and Choice and the Value of the Firm,” American Economic Review,
December 1988; and Avinash K. Dixit and Robert S. Pindyck, Investment under Uncertainty (Princeton, NJ:
Princeton University Press, 1993).

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 362 PART 4•BEHAVIORAL FOUNDATIONS

BOX 14-6 Credit Rationing

In the IS-LM model, interest rates are the only channel of transmission between financial mar-
kets and aggregate demand. Credit rationing is an important additional channel of transmis-
sion of monetary policy.* Credit rationing takes place when lenders limit the amount
individuals can borrow, even though the borrowers are willing to pay the going interest rate
on their loans. For example, during a short period in the 2007–2009 recession, credit be-
came unavailable even for many “creditworthy customers.”
Credit rationing can occur for two different reasons. First, a lender often cannot tell
whether a particular customer (or the project the customer is financing) is good or bad.
A bad customer will default on the loan and not repay it. Given the risk of default, the
obvious answer seems to be to raise the interest rate.
However, raising interest rates works the wrong way: Honest or conservative custom-
ers are deterred from borrowing because they realize their investments are not profitable at
higher interest rates. But customers who are reckless or dishonest will borrow because they
do not in any case expect to pay if the project turns out badly. However carefully they try to
evaluate their customers, the lenders cannot altogether escape this problem. The answer is to
limit the amount lent to any one customer. Most customers get broadly the same interest rate
(with some adjustments), but the amount of credit they are allowed is rationed, according to
both the kind of security the customer can offer and the prospects for the economy.
When times are good, banks lend cheerfully because they believe that the average
customer will not default. When the economy turns down, credit rationing intensifies—
and this may happen even though interest rates decline.
Credit rationing provides another channel for monetary policy. If lenders perceive
that the Fed is shifting to restraint and higher interest rates to cool down the economy,
lenders fearing a slowdown will tighten credit. Conversely, if they believe policy is
expansionary and times will be good, they ease credit, via both lower interest rates and
expanded credit rationing.†
A second type of credit rationing can occur when the central bank imposes credit limits
on commercial banks and other lenders. Banks are then not allowed to expand their loans
during a given period by more than, say, 5 percent or even less. Such a credit limit can bring
a boom to an abrupt end. A striking example occurred in the United States in early 1980.
Concerned with the risk of double-digit inflation, the Fed clamped on credit controls. In no
time the economy fell into a recession, with output falling at an annual rate of 9 percent.
Credit controls thus are an emergency brake for the central bank. They work, but
they do so in a very blunt way. For that reason, their use is very infrequent and remains
reserved for occasions when dramatic, fast effects are desired.

*For a comprehensive survey on credit rationing, see Dwight Jaffee and Joseph Stiglitz, “Credit Rationing” in
Ben Friedman and Frank Hahn (eds.), Handbook of Monetary Economics (Amsterdam: North-Holland, 1990).
†
Frederick Mishkin provides a readable introduction to the transmission mechanism between monetary policy and the
private economy in “Symposium on the Monetary Transmission Mechanism,” Journal of Economic Perspectives, Fall
1995. In the same issue, see also John B. Taylor, “The Monetary Transmission Mechanism: An Empirical Framework,”
Ben S. Bernanke and Mark Gertler, “Inside the Black Box: The Credit Channel of Monetary Policy Transmission,” and
Allan H. Meltzer, “Monetary, Credit (and Other) Transmission Processes: A Monetarist Perspective.”

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 CHAPTER 14•INVESTMENT SPENDING 363

◆OPTIONAL◆
The Business Investment Decision: The View from the Trenches
Businesspeople making investment decisions typically use discounted cash flow
analysis.10 The principles of discounting are described in Chapter 18. Consider a
businessperson deciding whether to build and equip a new factory. The first step is to
figure out how much it will cost to get the factory into working order and how much
revenue the factory will bring in each year after it starts operation.
For simplicity, consider a very short-lived project, one that costs $100 to set up in
the first year and then generates $50 in revenue (after paying for labor and raw materi-
als) in the second year and a further $80 in the third year. By the end of the third year
the factory has disintegrated.
Should the project be undertaken? Discounted cash flow analysis says that the
revenues received in later years should be discounted to the present in order to calculate
their present value. If the interest rate is 10 percent, $110 a year from now is worth the
same as $100 now. (See Chapter 18 for a more extended discussion.) Why? Because if
$100 is lent out today at 10 percent, a year from now the lender will end up with $110.
To calculate the value of the project, the firm calculates the project’s present discounted
value at the interest rate at which it can borrow. If the present value is positive, the proj-
ect is undertaken.
Suppose that the relevant interest rate is 12 percent. The calculation of the present
discounted value of the investment project is shown in Table 14-2. The $50 received in
year 2 is worth only $44.65 today: $1 a year from now is worth $11.12  0.893 today,
and so $50 a year from now is worth $44.65. The present value of the $80 received in
year 3 is calculated similarly. The table shows that the present value of the net revenue
received from the project is positive ($8.41); thus, the firm should undertake the project.
Note that if the interest rate had been much higher—say, 18 percent—the decision
would have been not to undertake the investment. We thus see that the higher the inter-
est rate, the less likely the firm will be to undertake any given investment project.

TABLE 14-2 Discounted Cash Flow Analysis and Present Value

(Dollars)
PRESENT
DISCOUNTED
YEAR 1 YEAR 2 YEAR 3 VALUE
Cash or revenue 100 50 80
Present value of $1 1 11.12  0.893 11.122  0.797
Present value of 100 50  0.893 80  0.797 100  44.65  63.76
costs or revenue  44.65  63.76  8.41

10
Discounted cash flow analysis and the rental-cost-equals-marginal-product-of-capital models are simply
different ways of thinking about the same decision process. You will sometimes hear businesspeople discuss-
ing what we call the marginal product of capital as the “internal rate of return.”

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 364 PART 4•BEHAVIORAL FOUNDATIONS

At any time, each firm has an array of possible investment projects and estimates
of the costs and revenues from those projects. Depending on the level of the interest
rate, the firm will want to undertake some of the projects and not undertake others.
Adding the investment demands of all the firms in the economy, we obtain the total
demand for investment in the economy at each interest rate.

RESIDENTIAL INVESTMENT

Figure 14-7 shows residential investment spending as a percentage of GDP, together

with the nominal mortgage interest rate. Residential investment is low when the mort-
gage interest rates are high, and it is high when the mortgage interest rates are low. Until
2001, residential investment declined during all recessions. However, this pattern broke
down during the 2001 recession—residential investment increased. This increase can be
explained by the lowest mortgage interest rates that the United States had experienced
over the last 30 years. By the year 2006, the housing sector had gone into decline as the
Fed raised interest rates.
Residential investment consists of the building of single-family and multifamily
dwellings, which we call housing for short. Housing is distinguished as an asset by its
long life. Consequently, investment in housing in any one year tends to be a very small
proportion—about 3 percent—of the existing stock of housing. The theory of residen-
tial investment starts by considering the demand for the existing stock of housing.
The demand for the housing stock depends on the net real return obtained by own-
ing housing. The gross return—before taking costs into account—consists either of
rent, if the housing is rented out, or of the implicit return that the homeowner receives
by living in the home plus capital gains arising from increases in the value of the hous-
ing. In turn, the costs of owning the housing consist of interest costs, typically the mort-
gage interest rate, plus any real estate taxes and depreciation. These costs are deducted

18
16
14
12 Mortgage
Percent

10 interest rate

8
6
4
Residential
2 investment/GDP
0
1975 1980 1985 1990 1995 2000 2005 2010

FIGURE 14-7 RESIDENTIAL INVESTMENT AND MORTGAGE INTEREST RATES, 1973–2010.

(Source: Bureau of Economic Analysis and Federal Reserve Economic Data [FRED II].)

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 CHAPTER 14•INVESTMENT SPENDING 365

from the gross return and, after tax adjustments, constitute the net return. An increase in
the net return on housing, caused, for example, by a reduction in the mortgage interest
rate, makes housing a more attractive form in which to hold wealth.

MONETARY POLICY AND HOUSING INVESTMENT

Monetary policy has powerful effects on housing investment. Part of the reason is that
most houses are purchased with mortgages. Since the 1930s, a mortgage in the United
States has typically been a debt instrument of very long maturity, 20 to 30 years, with
fixed monthly repayments until maturity.11
Monetary policy has powerful effects on housing investment because the demand
for housing is sensitive to the interest rate. There is sensitivity to both the real and the
nominal interest rates. The reason for this sensitivity can be seen in Table 14-3, which
shows the monthly payment that has to be made by someone borrowing $100,000
through a conventional mortgage at different interest rates. All these interest rates have
existed at some time during the last 30 years: 10 percent at the end of the 1970s and end
of the 1980s, 15 percent in 1981 and 1982, and 5.5 percent in spring 2003. The monthly
repayment by the borrower approximately doubles when the interest rate doubles. Thus,
an essential component of the cost of owning a home rises almost proportionately with
the interest rate. It is therefore not surprising that the demand for housing is very sensi-
tive to the interest rate.
Table 14-3 also shows the effect of taxes and inflation on housing costs. In the
United States, interest payments on a principal residence are deductible from the per-
sonal income tax. The deduction, not available in many other countries, is part of a de-
liberate attempt to encourage individual homeownership. A further feature of the U.S.
tax system is that nominal interest payments are deductible and nominal capital gains

TABLE 14-3 Monthly Payments on Mortgages*

CIRCA 1982 CIRCA 1988 CIRCA 2003
Nominal interest rate, % 15 10 5.5
Inflation rate, % 10 5 0
Real interest rate, % 5 5 5.5
Monthly payment, $ 1,264 878 568
After-tax payment, $ 885 614 397
Real after-tax payment, $ 52 198 397

*The assumed mortgage is a loan for $100,000 paid back over 30 years, with equal monthly payments throughout the
30 years. A 30 percent tax rate is assumed, and real after-tax payments assume capital gains are effectively untaxed.

11
Adjustable rate mortgages (ARMs) were introduced in the United States in the 1970s. The interest rate on
such mortgages is adjusted in accordance with some reference rate, such as the 1-year Treasury-bill rate. Both
fixed rate mortgages and ARMs are now used to finance housing. Arrangements for housing finance differ
significantly across countries. Five-year renewable mortgages are common in Canada. In Japan and Korea,
home buyers (and family) provide more housing funding than is common in the United States.

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 366 PART 4•BEHAVIORAL FOUNDATIONS

due to inflation are essentially untaxed. This means that the combination of high
nominal rates and high inflation strongly encourages housing investment. Consider pay-
ments on a $100,000 mortgage when the nominal interest rate is 15 percent and the in-
flation rate is 10 percent. Annual interest is approximately $15,000. For a homeowner in
the 30 percent marginal tax bracket, the mortgage interest deduction is $4,500, so the
after-tax interest cost is approximately $10,500. But at 10 percent inflation, this cost is
offset by a $10,000 increase in the nominal value of the house. In effect, the real cost of
capital for the house is nearly zero.
Despite this analysis, high nominal interest rates do discourage homeownership
because of two kinds of liquidity effects. First, the homeowner has to make the full
nominal payments up front and receives the offsetting capital gain far in the future. Sec-
ond, banks use rules of thumb to qualify mortgage applicants (e.g., that payments can be
no more than 28 percent of income) that don’t adjust very much in periods of high infla-
tion. Both these liquidity effects depend on the nominal, not real, interest rate.

INVENTORY INVESTMENT

Inventories consist of raw materials, goods in the process of production, and com-
pleted goods held by firms in anticipation of the products’ sale. The ratio of manu-
facturing inventories to sales in the United States was in the range of 13 to 17 percent
until about 1990. Since then the ratio has fallen and is now around 11 percent, as indi-
cated in Figure 14-8. Adoption of just-in time manufacturing techniques has contributed
to this decline.

17

16

15

14
Percent

13

12

11

10

9
1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

FIGURE 14-8 RATIO OF MANUFACTURING INVENTORIES TO SALES.

(Source: U.S. Census Bureau, Current Industrial Reports, Manufacturers’ Shipments,
Inventories, and Orders.)

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 CHAPTER 14•INVESTMENT SPENDING 367

Firms hold inventories for several reasons:

• Sellers hold inventories to meet future demand for goods, because goods cannot be
instantly manufactured or obtained to meet demand.
• Inventories are held because it is less costly for a firm to order goods less frequently
in large quantities than to order small quantities frequently—just as the average
householder finds it is useful to keep several days’ worth of groceries in the house to
avoid having to visit the supermarket daily.
• Producers may hold inventories as a way of smoothing their production. Since it is
costly to keep changing the level of output on a production line, producers may pro-
duce at a relatively steady rate even when demand fluctuates, building up inventories
when demand is low and drawing them down when demand is high.
• Some inventories are held as an unavoidable part of the production process. There is
an inventory of meat and sawdust inside the sausage machine during the manufac-
ture of sausage, for example.
Firms have a desired ratio of inventories to final sales that depends on economic
variables. The smaller the cost of ordering new goods and the greater the speed with
which such goods arrive, the smaller the inventory-sales ratio. The inventory-sales ratio
may also depend on the level of sales, with the ratio falling with sales because there is
relatively less uncertainty about sales as sales increase.
Finally, there is the interest rate. Since firms carry inventories over time, the firms
must tie up resources in order to buy and hold the inventories. There is an interest cost
involved in such inventory holding, and the desired inventory-sales ratio should be ex-
pected to fall with increases in the interest rate.

The Accelerator Model

All these considerations notwithstanding, inventory investment can be explained sur-
prisingly well with the simple accelerator model. The accelerator model asserts that
investment spending is proportional to the change in output and is not affected by
the cost of capital, I 
(Y  Y1).12 Figure 14-9 compares inventory investment
to the change in GDP. Much, but not all, inventory investment can be explained this
way. The connection of the level of inventory investment to the change in output is an
important channel adding to the overall volatility of the economy.

Anticipated versus Unanticipated Inventory Investment

Inventory investment takes place when firms increase their inventories. The central
aspect of inventory investment lies in the distinction between anticipated (desired) and
unanticipated (undesired) investment. Inventory investment could be high in two cir-
cumstances. First, if sales are unexpectedly low, firms would find unsold inventories
accumulating on their shelves; that constitutes unanticipated inventory investment. Sec-
ond, inventory investment could be high because firms plan to build up inventories; that
is anticipated or desired investment.

12
The accelerator model is actually a special case of the flexible accelerator. (The former came first.) To see
this, ignore the role of the rental cost and set  1 in the formula for the flexible accelerator.

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