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Investment

Macroeconomic Theory I

ECON222

Fall 2017

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 1 / 12


The role of investment

Here we are referring to spending on physical capital goods


Accounts for about 20% of GDP on average, but uctuates sharply
over the business cycle
,! contributes about 50% of the total decline in GDP during recessions

Investment is crucial for the long-run productive capacity of the


economy and its growth.

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The desired capital stock basic model

The level of capital at which rms maximize their prots

Managers compare the cost and benet of using additional capital,


e.g. a new machine.
,! the rms benet is MPK f the future MPK.
,! the rms cost is the user cost of capital.

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 4 / 12


The user cost of capital

This is the expected real cost of using a unit of capital for a specied
period of time

It can be expressed as
uc = (r + d )pK
where

= the expected real rate of interest


r
d = the rate at which capital depreciates
pK = the real price of capital goods

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 5 / 12


Determining the desired capital stock

The desired capital stock, K , is the capital stock at which MPK f


equals uc

The MPK f curve slopes downward due to diminising returns

The uc curve does not depend on K and is a horizontal line

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 6 / 12


$

uc1

f
MPK

K*1 K
Figure: Determination of desired capital

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 7 / 12


Changes in the desired capital stock

If r falls, uc falls =) MPK f > uc, and so K rises


,! the same is true when d or pK fall

When technology improves, the MPK f curve shifts up


=) MPK f > uc and so K rises.

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 8 / 12


$

uc2
uc1

f
MPK

K*2 K*1 K

Figure: Increase in the interest rate

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 9 / 12


Taxes and the desired capital stock

If denotes the eective tax rate on capital, the after-tax MPK f is


(1 )MPK f

It follows that K will be chosen so that


uc
MPK f =
1
| {z }
tax-adjusted uc

An increase in raises the tax-adjusted user cost and so reduces K

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 10 / 12


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Investment dynamics

Let It denote gross investment in period t


,! the total purchase or construction of new capital goods

Net investment (the change in the capital stock) is then

Kt + 1 Kt = It d.Kt

If Kt +1 = K , desired investment is

Itd = K (1 d ) Kt

Macroeconomic Theory I (ECON222) Consumption, Savings & Investment Fall 2017 12 / 12