18.4 Conclusion

The purpose of this chapter has been to examine the determinants of investment in more detail. Looking back on the various models of investment, we can see three themes.

First, all types of investment spending are inversely related to the real interest rate. A higher interest rate raises the cost of capital to firms that invest in plant and equipment, raises the cost of borrowing to home buyers, and raises the cost of holding inventories. Thus, the models of investment developed here justify the investment function we have used throughout this book.

Second, there are various causes of shifts in the investment function. An improvement in the available technology raises the marginal product of capital and raises business fixed investment. An increase in the population raises the demand for housing and raises residential investment. Finally, various economic policies, such as changes in the investment tax credit and the corporate profit tax, alter the incentives to invest and thus shift the investment function.

Third, it is natural to expect investment to be volatile over the business cycle, because investment spending depends on the output of the economy as well as on the interest rate. In the neoclassical model of business fixed investment, higher employment raises the marginal product of capital and the incentive to invest. Higher output also raises firms’ profits and, thereby, relaxes the financing constraints that some firms face. In addition, higher income raises the demand for houses, in turn raising housing prices and residential investment. Higher output raises the stock of inventories firms wish to hold, stimulating inventory investment. Our models predict that an economic boom should stimulate investment and a recession should depress it. This is exactly what we observe.