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Investment: Q Qu Ue Essttiio On Nss Ffo Orr R Re Ev Viie Ew W
Investment: Q Qu Ue Essttiio On Nss Ffo Orr R Re Ev Viie Ew W
Investment: Q Qu Ue Essttiio On Nss Ffo Orr R Re Ev Viie Ew W
Demand
KH IH
Stock of housing Investment in housing
165
166 Answers to Textbook Questions and Problems
Figure 172
r
LM
Interest rate
G/(1 MPC a)
IS2
IS1
Y
Income, output
From the figure, it is clear that national income and the interest rate
increase. Since income is higher, consumption is higher as well. We cannot tell
whether investment rises or falls: the higher interest rate tends to make invest-
ment fall, whereas the higher national income tends to make investment rise.
In the standard model where investment depends only on the interest rate,
an increase in government purchases unambiguously causes investment to fall.
That is, government purchases crowd out investment. In this model, an increase
in government purchases might instead increase investment in the short run
through the temporary expansion in Y.
4. A stock market crash implies that the market value of installed capital falls. Tobins
qthe ratio of the market value of installed capital to its replacement costalso falls.
This causes investment and hence aggregate demand to fall.
If the Fed seeks to keep output unchanged, it can offset this aggregate-demand
shock by running an expansionary monetary policy.
5. If managers think the opposition candidate might win, they may postpone some invest-
ments that they are considering. If they wait, and the opposition candidate is elected,
then the investment tax credit reduces the cost of their investment. Hence, the cam-
paign promise to implement an investment tax credit next year causes current invest-
ment to fall. This fall in investment reduces current aggregate demand and output: the
recession deepens.
Note that this deeper recession makes it more likely that voters vote for the oppo-
sition candidate instead of the incumbent, making it more likely that the opposition
candidate wins.
Chapter 17 Investment 169
6. a. In the 1970s, the baby-boom generation reached adulthood and started forming
their own households. This implies that in our model of residential investment,
demand for housing rose. As shown in Figure 173, this causes housing prices and
residential investment to rise.
FiFigure
gure 1173
73
PH/P PH/P
Supply
Relative price of housing
Demand
KH IH
Stock of housing Investment in housing
b. The Economic Report of the President 1999 (Table B7) reports that in 1970, the
real price of housingthe ratio of the residential investment deflator to the GDP
deflatorwas 27.74/30.48, or 0.91. In 1980, this ratio had risen to 66.62/60.34, or
1.10. Thus, between 1970 and 1980 the real price of housing rose 21 percent. This
finding is consistent with the prediction of our model.
170 Answers to Textbook Questions and Problems
7. Consider the Solow growth model from Chapters 4 and 5. The Solow model shows that
the saving rate is a key determinant of the steady-state capital stock. If the tax laws
encourage investment in housing but discourage investment in business capital, this
implies that the fraction of output devoted to business investment is lower because of
the tax consequences. Figure 174 shows the outcome of the Solow model for low and
high saving rates. At the lower saving rate, business capital-per-worker and business
output-per-worker is also lower. Thus, the tax system distorts the economys choice of
business output versus housing.
An alternative way to see this effect is to think of the labor market. With less capi-
tal for each worker, the marginal product of labor is lower. Hence, in the long run, the
real wage of workers is lower because of the distortions of the tax system.
Figure 174
(n + ) k
Investment, breakeven investment
sH f (k)
sL f (k)
k*L k*H k
Business capital per worker