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Questions for Review
1. In the neoclassical model of business fixed investment, firms will find it profitable to
2. Tobin’s qis the ratio of the market value of installed capital to its replacement cost.
Tobin reasoned that net investment should depend on whether qis greater or less than
one. If qis greater than one, then the stock market values installed capital at more
than it costs to replace. This creates an incentive to invest, because managers can raise
3. An increase in the interest rate leads to a decrease in residential investment because it
reduces housing demand. Many people take out mortgages to purchase their homes,
and a rise in the interest rate increases the cost of the loan. Even for people who do not
borrow to buy a home, the interest rate measures the opportunity cost of holding their
wealth in housing rather than putting it in the bank.
Figure 18–1 shows the effect of an increase in the interest rate on residential
investment. The higher interest rate shifts the demand curve for housing to the left, as
shown in Figure 18–1(A). This causes the relative price of housing to fall, and as shown
in Figure 18–1(B), the lower relative price of housing decreases residential investment.
187
Supply Supply
PH/P PH/P
A. The Market for Housing B. The Supply of New Housing
Figure 18–1
CHAPTER 18 Investment
4. Reasons why firms might hold inventories include:
a. Production smoothing. A firm may hold inventories to smooth the level of produc-
tion over time. Rather than adjust production to match fluctuations in sales, it
may be cheaper to produce goods at a constant rate. Hence, the firm increases
inventories when sales are low and decreases them when sales are high.
Problems and Applications
1. In answering parts (a) to (c), it is useful to recall the neoclassical investment function:
I= In[MPK – (PK/P)(r+ δ)] + δK.
This equation tells us that business fixed investment depends on the marginal product
of capital (MPK), the cost of capital (PK/P)(r+ δ), and the amount of depreciation of the
2. Recall the equation for business fixed investment:
I= In[MPK – (PK/P)(r+ δ)] + δK.
This equation tells us that business fixed investment depends on the marginal product
of capital, the cost of capital, and the amount of depreciation of the capital stock.
A one-time tax levied on oil reserves does not affect the MPK: the oil companies
3. a. There are several reasons why investment might depend on national income.
First, from the neoclassical model of business fixed investment we know that an
188 Answers to Textbook Questions and Problems
b. In the Keynesian cross model of Chapter 10, we assumed that I=
I
. We found the
government-purchases multiplier by considering an increase in government
expenditure of ΔG. The immediate effect is an increase in income of ΔG. This
increase in income causes consumption to rise by MPC ×ΔG. This increase in con-
sumption increases expenditure and income once again. This process continues
indefinitely, so the ultimate effect on income is
ΔY= ΔG[1 + mpc + mpc2+ mpc3+ . . . ]
= (1/(1 – MPC))ΔG.
Chapter 18 Investment 189
c. The government-purchases multiplier in the Keynesian cross tells us how output
responds to a change in government purchases, for a given interest rate.
Therefore, it tells us how much the IS curve shifts out in response to a change in
government purchases. If investment depends on both income and the interest
4. A stock market crash implies that the market value of installed capital falls. Tobin’s
q—the ratio of the market value of installed capital to its replacement cost—also falls.
This causes investment and hence aggregate demand to fall.
If the Fed seeks to keep output unchanged, it can offset this aggregate-demand
shock by running an expansionary monetary policy.
5. If managers think the opposition candidate might win, they may postpone some invest-
ments that they are considering. If they wait, and the opposition candidate is elected,
then the investment tax credit reduces the cost of their investment. Hence, the cam-
190 Answers to Textbook Questions and Problems
6. a. In the 1970s, the baby-boom generation reached adulthood and started forming
their own households. This implies that in our model of residential investment,
demand for housing rose. As shown in Figure 18–3, this causes housing prices and
residential investment to rise.
b. The Economic Report of the President 2009 (Table B–7) reports that in 1970, the
real price of housing—the ratio of the residential investment deflator to the GDP
deflator—was 21.53/27.54, or 0.78. In 1980, this ratio had risen to 51.39/54.06, or
Chapter 18 Investment 191
Supply
PH/P
PH/P
Figure 18–3
7. Consider the Solow growth model from Chapters 7 and 8. The Solow model shows that
the saving rate is a key determinant of the steady-state capital stock. If the tax laws
encourage investment in housing but discourage investment in business capital, this
implies that the fraction of output devoted to business investment is lower because of
the tax consequences. Figure 18–4 shows the outcome of the Solow model for low and
high saving rates. At the lower saving rate, business capital-per-worker and business
192 Answers to Textbook Questions and Problems
