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Investment: most volatile component of GDP
3 Types of Investment spending:
- Business Fixed Investment: investment goods (equipment & structures bought) by firms for future production
- Residential Investment: includes new housing people buy to live in & landlords buy to rent.
- Inventory Investment: includes those goods businesses put aside in storage, incl. Materials & supplies, work in progress, and finished goods.
Why is inv negatively related to the i. rate?
All types of inv inversely related to the real i. rate.
Higher i. rate:
- raises cost of capital to firms that invest in plant,
- raise cost of borrowing to home buyers,
- raise cost of holding inventories.
What causes the investment function to shift?
Various causes:
- an improvement in the available technology raises marginal product of capital & raises business fixed investment.
- an increase in population raises demand for housing & raises residential inv.
- most imp: various eco policies, such as Δs in the investment tax credit and corporation tax, alter the incentive to invest & thus shift inv function.
Why does inv rise during booms & fall during recessions?
- Natural to expect inv to be volatile over the business cycle, cos inv spending depends on output as well as i. rates.
- In Neoclassical model of business fixed inv, higher employment raises marginal product of capital & the incentives to invest.
- Higher output: raises firms’ profits, relaxing financing constraints.
- Higher Output: raises stock of inventories firms wish to hold, stimulating inventory inv.
- Higher income: raises demand for houses, in turn raising house Ps and residential inv.
Business Fixed Investment
Neoclassical Model of Investment: examines costs & benefits to firms of owning capital goods.
Shows how level of fixed investment is related to
- Marginal Product of Capital,
- The Interest rate, &
- The Tax Rules Affecting Firms.
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