The marginal product of capital determines the real rental price of capital. The real interest rate, the depreciation rate, and the relative price of capital goods determine the cost of capital. According to the neoclassical model, firms invest if the rental price is greater than the cost of capital, and they disinvest if the rental price is less than the cost of capital.
Various parts of the federal tax code influence the incentive to invest. The corporate income tax discourages investment, and the investment tax credit—which has now been repealed in the United States—encourages it.
An alternative way of expressing the neoclassical model is to state that investment depends on Tobin’s q, the ratio of the market value of installed capital to its replacement cost. This ratio reflects the current and expected future profitability of capital. The higher q is, the greater the market value of installed capital relative to its replacement cost and the greater the incentive to invest.
Economists debate whether fluctuations in the stock market are a rational reflection of companies’ true value or are driven by irrational waves of optimism and pessimism.
In contrast to the assumption of the neoclassical model, firms cannot always raise funds to finance investment. Financing constraints make investment sensitive to firms’ current cash flow.
Residential investment depends on the relative price of housing. Housing prices in turn depend on the demand for housing and the current fixed supply. An increase in housing demand, perhaps attributable to a fall in the interest rate, raises housing prices and residential investment.
Firms have various motives for holding inventories of goods: smoothing production, using them as a factor of production, avoiding stock-outs, and storing work in process. How much inventories firms hold depends on the real interest rate and on credit conditions.
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