PROBLEMS AND APPLICATIONS

To access online learning resources, visit for Macroeconomics, 9e at www.macmillanhighered.com/launchpad/mankiw9e

Question 17.5

1. Use the neoclassical model of investment to explain the impact of each of the following on the rental price of capital, the cost of capital, and investment.

  1. Anti-inflationary monetary policy raises the real interest rate.

  2. An earthquake destroys part of the capital stock.

  3. Immigration of foreign workers increases the size of the labor force.

  4. Advances in computer technology make production more efficient.

Question 17.6

2. Suppose that the government levies a tax on oil companies equal to a proportion of the value of the company’s oil reserves. (The government assures the firms that the tax is for one time only.) According to the neoclassical model, what effect will the tax have on business fixed investment by these firms? What if these firms face financing constraints?

Question 17.7

3. The IS–LM model developed in Chapter 11 and Chapter 12 assumes that investment depends only on the interest rate. Yet our theories of investment suggest that investment might also depend on national income: higher income might induce firms to invest more.

  1. Explain why investment might depend on national income.

  2. Suppose that investment is determined by

    where a is a parameter between zero and one, which measures the influence of national income on investment. With investment set this way, what are the fiscal-policy multipliers in the Keynesian-cross model? Explain.

  3. Suppose that investment depends on both income and the interest rate. That is, the investment function is

where a is a parameter between zero and one that measures the influence of national income on investment and b is a parameter greater than zero that measures the influence of the interest rate on investment. Use the IS–LM model to consider the short-run impact of an increase in government purchases on national income Y, the interest rate r, consumption C, and investment I. How might this investment function alter the conclusions implied by the basic IS–LM model?

530

Question 17.8

4. When the stock market crashes, what influence does it have on investment, consumption, and aggregate demand? Why? How should the Federal Reserve respond? Why?

Question 17.9

5. It is an election year, and the economy is in a recession. The opposition candidate campaigns on a platform of passing an investment tax credit, which would be effective next year after she takes office. What impact does this campaign promise have on economic conditions during the current year?

Question 17.10

6. The United States experienced a large increase in the number of births in the 1950s. People in this baby-boom generation reached adulthood and started forming their own households in the 1970s.

  1. Use the model of residential investment to predict the impact of this event on housing prices and residential investment.

  2. Go to the Federal Reserve Economic Data (FRED) Web site to find data. For the years 1970 and 1980, compute the real price of housing, measured as the residential investment deflator divided by the GDP deflator. What do you find? Is this finding consistent with the model?

Question 17.11

7. U.S. tax laws encourage investment in housing (such as through the deductibility of mortgage interest for purposes of computing taxable income) and discourage investment in business capital (such as through the corporate income tax). What are the long-run effects of this policy? (Hint: Think about the labor market.)

1 Economists often measure capital goods in units such that the price of 1 unit of capital equals the price of 1 unit of other goods and services (PK = P). This was the approach taken implicitly in Chapter 8 and Chapter 9, for example. In this case, the steady-state condition says that the marginal product of capital net of depreciation, MPK − d, equals the real interest rate r.

2 A classic study of how taxes influence investment is Robert E. Hall and Dale W. Jorgenson, “Tax Policy and Investment Behavior,” American Economic Review 57 (June 1967): 391–414. For a study of the recent corporate tax changes, see Christopher L. House and Matthew D. Shapiro, “Temporary Investment Tax Incentives: Theory With Evidence From Bonus Depreciation,” American Economic Review 98 (June 2008): 737–768.

3 To read more about the relationship between the neoclassical model of investment and q theory, see Fumio Hayashi, “Tobin’s Marginal q and Average q: A Neoclassical Approach,” Econometrica 50 (January 1982): 213–224; and Lawrence H. Summers, “Taxation and Corporate Investment: A q-Theory Approach,” Brookings Papers on Economic Activity 1981, no. 1: 67–140.

4 A classic reference on the efficient markets hypothesis is Eugene Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25 (1970): 383–417. For the alternative view, see Robert J. Shiller, “From Efficient Markets Theory to Behavioral Finance,” Journal of Economic Perspectives 17 (Winter 2003): 83–104.

5 For empirical work supporting the importance of these financing constraints, see Steven M. Fazzari, R. Glenn Hubbard, and Bruce C. Petersen, “Financing Constraints and Corporate Investment,” Brookings Papers on Economic Activity 1988, no. 1: 141–195.