HO #5

Aggregate Investment Function

Lets start with the simple Keynesian investment function: It = AI f(i) where: AI intercept of the investment function, or what investment expenditures would be if interest rates were zero f slope of the investment function, or the change in investment with respect to a change in the interest rate (known as the marginal efficiency of investment) i rate of interest It gross investment expenditures Capital stock: The desired productive capital stock of businesses at the end of the year would be given by: K*t = Kt-1 + It Dt where: K*t desired productive capital stock (plant and equipment) at the end of the year

Kt-1 productive capital stock (plant and equipment) at the beginning of the year Dt depreciation during the year Net investment expenditures: Net investment is equal to gross investment, or new capital expenditures, minus depreciation is given by: NIt = It -Dt where It (gross investment expenditures) and Dt (depreciation). Depreciation here also represents replacement investment. Aggregate Production: The aggregate production for all businesses taken together can be represented by the following function: Yt = aLt [{K*t +Kt-1}/2]

where: a production constant Lt size of the labor force partial elasticity of production with respect to labor ( Y/ L)

Kt-1

existing productive capital stock partial elasticity of production with respect to capital ( Y/ K)

Interest Rate Effects on Investment and Labor: We know that a contractionary monetary policy action will raise interest rates. When this occurs, the following chain of events can be expected: it It K*t Yt Lt This suggests that an increase in interest rates dampens planned investment expenditures. This will reduce productive capacity growth and potential output and reduces the need for labor to produce the lower output. This will increase unemployment rate. We know that a expansionary monetary policy action will lower interest rates. When this occurs, the following chain of events can be expected: it It K*t Yt Lt This suggests that a decrease in interest rates enhances planned investment expenditures, which

expands productive capacity and planned potential output. This will increase employment (decrease the unemployment rate).