Economics Chapter 19 Us Government During That Period Was Hotly

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Chapter 19

Investment

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline

Data on Investment Spending

The Neoclassical Theory of Investment

Determining the Level of Capital Stock

Inventory Investment

Motivation for Holding Inventories

The Theory of Inventory Investment

Tobin’s q and Investment

Application: Stock Market Crashes and Recessions

Residential Investment

Policy and Practice: U.S. Government Policies and the Housing Market

Chapter 19 Web Appendix: A Model of Housing Prices and Residential Investment

Determination of Housing Prices

Application: Boom and Bust in the Housing Market, 2001-2009

Chapter Overview and Teaching Tips

This chapter continues the discussion of the microeconomic foundations by developing two basic models

Chapter 19 Investment 221

marginal product of capital to the rental cost of capital; second, the rental cost of capital is linked to the

concept of the user cost of capital; and third, showing how the desired level of capital determines investment.

The theory of inventory investment is then described briefly because it is just a variant of the neoclassical

theory, and then the chapter develops Tobin’s q theory. It is important to get across to students that Tobin’s

q theory is completely consistent with neoclassical theory but emphasizes the impact of asset prices on

Student interest given the recent housing boom and bust is so high that teaching a more complete model

that discusses the determination of housing prices and investment can be very interesting. The more

extensive model is described in an online appendix that can be found on the Companion Website at

www.pearsonhighered.com/mishkin. The model on the Website is a combination of the neoclassical model

and Tobin’s q theory, so teaching it also has the advantage of giving students more practice with both

theories. It proceeds step by step, with the neoclassical model being used to show how housing prices are

◼ Answers to End of Chapter Review Questions and Problems

Answers to Review Questions

Data on Investment Spending

1. The three components of investment spending are business fixed investment, which includes

The Neoclassical Theory of Investment

2. The user cost of capital is the expected real cost of using (or renting) a unit of capital over a particular

time period. It is determined by the real price of a unit of capital, the real interest rate (which measures

the interest cost or opportunity cost of the funds used to purchase the unit of capital), the expected

222 Mishkin • Macroeconomics: Policy and Practice, Second Edition

3. The user cost of capital is fixed by the values of the real price of a unit of capital, the real interest

rate, the expected rate of change in the real price of capital, and the depreciation rate. As the capital

stock increases, the expected marginal product of capital diminishes. The desired level of capital is

4. Firms compare their desired level of capital with their current capital stock to determine the change in

their capital stock that will bring it to the desired level. The net investment spending they must undertake

5. The expected marginal product of capital changes when expected future income changes. If total factor

productivity or employment is expected to rise, expected future income rises, firms’ expected marginal

product of capital increases, and the desired levels of capital and investment both go up. When expected

Inventory Investment

6. Firms hold inventories for several reasons. Inventories of raw materials, components, spare parts, and

work in progress are important resources used in the production of goods and services. Holding

inventories of finished goods enables firms to maintain stable flows of production even if their sales

most volatile component of investment spending and plays an important role in business cycles.

Tobin’s q and Investment

7. Tobin’s q is the ratio of the market value of installed capital to the replacement cost of that capital.

For an individual firm, the market value of installed capital is reckoned as the stock market’s

valuation of the firm’s stock. When q is greater than 1, the stock market values the firm more highly

Chapter 19 Investment 223

8. The prediction from Tobin’s q theory that investment will increase when stock prices rise is reflected

in the neoclassical prediction that investment will increase when expected profits from adding capital

Residential Investment

9. There are four determinants of residential investment. A rise in mortgage rates raises the user cost of

housing and, hence, lowers the desired residential capital stock and residential investment. A rise in

10. The U.S. government has given tax preferences to encourage home ownership by allowing tax

deductibility of mortgage interest payments. It has also encouraged home ownership by establishing

Answers to Problems

The Neoclassical Theory of Investment

1. a. User cost for construction equipment = $600,000  (0.05 – 0 + 0.10) = $90,000

224 Mishkin • Macroeconomics: Policy and Practice, Second Edition

3. a. Everything else the same, easing monetary policy implies lower real interest rates, which results

in a decrease in the user cost of capital. The decrease in the user cost of capital translates into a

4. The Obama administration announced an investment tax credit as a part of a more comprehensive

plan (the American Recovery and Investment Act of 2009) to encourage investment and employment

in the United States during the 2007–2009 crisis. An investment tax credit of 30 percent is applied to

5. Less-developed financial systems often result in more difficult access to funds for firms that want to

increase their capital stock. The relative inefficiency of developing countries’ financial systems usually

arises from improperly designed property rights and the prevalence of asymmetric information problems.

6. a. New or stricter regulations that ask for tighter controls or enhanced security usually result in

more expensive drilling operations. Everything else the same, the user cost of capital increases,

Inventory Investment

7. Private inventories did not change by much during the first quarters of 2007. As the subprime

financial crisis affected the economy and firms observed a decline in the demand for their products,

production fell and companies decreased their inventories of finished goods and raw materials at a

relatively low pace. (Change in inventories was still positive for some time, as firms could not sell

Chapter 19 Investment 225

Tobin’s q and Investment

8. The doubling of stock prices raised the market value of firms relative to the replacement cost of

Residential Investment

9. The recent trend of single-person households can be interpreted as an increase in the demand for

housing, as more individuals demand housing. In the short run, the increase in housing demand

10. An increase in real interest rates would increase the user cost of residential investment, and so the

desired stock of residential housing would fall, leading to a decline in residential investment.

◼ Answers to Data Analysis Problems

1. a. Inventory investment for 2013:Q2 equals total investment minus business fixed investment minus

residential investment, which is $66.65 billion; thus, there was a net increase in inventories for

the quarter.

b. From 2000:Q1 to 2013:Q2, the average share of inventory investment is 1.22 percent. Although

2. a. For 2013:Q2, net investment is $594.1 billion, and gross investment is $3,225.2 billion. The two

are not equal, as the difference represents the amount of capital depreciation. There is a

3. a. Between 2012:Q2 and 2013:Q2, the average mortgage rate decreased from 3.80 percent to 3.69

percent; during this same period, residential investment increased from $425.7 billion to $513

billion, an increase of 20.5 percent. This is sensible because lower mortgage rates should

decrease the user cost of capital and thereby increase residential investment.

226 Mishkin • Macroeconomics: Policy and Practice, Second Edition

c. See scatterplot below. The fitted equation is %ΔRI = –0.5424NT + 3.7542, with a reasonably

good fit to the data as R2 = 0.71. For every 10 percentage point increase (tightening) of credit

standards (NT), residential investment growth (%ΔRI) is predicted to decrease by about 5.4

percentage points.

◼ Answers to Review Questions and Problems in Web Appendix, “A

Model of Housing Prices and Residential Investment”

1. At any given time, the existing stock of houses is fixed, and fluctuations in housing prices result from

fluctuations in demand. Increases in the demand for housing cause the price of housing to rise relative

2. The neoclassical theory of investment provides the answers here. In neoclassical theory, the desired

level of capital depends on the expected marginal product of capital and the user cost of capital.

When the expected marginal product of housing rises, the demand for housing increases. This occurs

Chapter 19 Investment 227

3. The positive effect on housing prices and housing starts of low mortgage rates, which would lower

the user cost of housing, was offset by concerns that housing prices might keep falling which would

4. An increase in real interest rates increases the user cost of residential investment and, therefore,

decreases the demand for housing. Graphically, the demand curve shifts to the left, and the new

equilibrium point determines a lower relative price of housing. In turn, residential investment

decreases as the relative price of housing decreases.

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Application: Stock Market Crashes and Recessions

Data Source

Federal Reserve Bank of St. Louis database (FRED):

domestic private investment. Edit the observation date range to 2006 to 2010 to observe the decline in

gross domestic private investment in that period.

Federal Reserve Bank of Boston, “Lessons for the Future from the Financial Crisis”:

Discussion Question

Suppose that Tobin’s q for a given company is currently less than 1. What would you do if you were

Gordon Gekko?

Answer: Gordon Gekko is a fictional character in the movie Wall Street (1987) who exploited profitable

228 Mishkin • Macroeconomics: Policy and Practice, Second Edition

B. For Information About Policy and Practice: U.S. Government Policies and

the Housing Market

Data Source

find a lot of information about the Obama administration’s home ownership policy.

Washington Times, “Cover story: Buying home still American dream” (11/22/2010):

Discussion Questions

Besides being part of the “American Dream,” as some claim, what are the other benefits of becoming a

homeowner? Are these reasons enough to justify government policies to promote home ownership?

Answer: Although having one’s own home might well be the most important reason individuals choose to

C. For Information About Application: Boom and Bust in the Housing Market,

2001–2009

Data Source

S&P Case/Shiller Housing Price Index: http://us.spindices.com/index-family/real-estate/sp-case-shiller

Here you can find the index and year-to–year changes in housing prices in the United States during the

2000s.

Board of Governors of the Federal Reserve System, “A View from the Federal Reserve Board: The

Mortgage Market and Housing Conditions”:

Discussion Question

The Federal Reserve lowered the federal funds rate target to near zero in late 2008 and maintained that

target until late 2010. This lowered mortgage rates but did not spur an increase in residential investment.

Using the neoclassical theory of investment, explain why this decrease in mortgage rates did not result in

increased residential investment.

Chapter 19 Investment 229

Answer: Even if mortgage rates were low during 2008–2010, residential investment did not increase at the