Econ 202: Macroeconomics

Consumption, Saving and Investment

Investment

Alpay Filiztekin
Investment

Investment

Investment spending is part of the aggregate demand for goods

and services, but it also represents the acquisition of new
capital goods by firms.

Capital accumulation can be written as:

Kt+1 = It + (1 − δ)Kt
where δ is depreciation rate.

Like consumption and saving decisions, the decision about how

much to invest depends largely on expectations about the
economy’s future.

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Investment

Investment

There are two main reasons to study investment behavior:

• More so than the other components of aggregate
spending, investment spending fluctuates sharply over the
business cycle, falling in recessions and rising in booms.
• Investment plays a crucial role in determining the long-run
productive capacity of the economy.

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Investment

The Desired Capital Stock

For a profit-maximizing firm, the desired capital stock is the

amount of capital that allows the firm to earn the largest
expected profit.

The profit-maximizing level of the capital stock is determined by

comparing the costs and benefits of using additional capital.

(If the benefits out-weigh the costs, expanding the capital stock will raise
profits. But if the costs outweigh the benefits, the firm shouldn’t increase its
planned capital stock and may even want to reduce it.)

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Investment

The Desired Capital Stock

In real terms, the benefit to a firm of having an additional unit of

capital is the marginal product of capital, MPK , the increase in
output that a firm can obtain by adding a unit of capital, holding
constant the firm’s work force and other factors of production.

Because lags occur in obtaining and installing new capital, the

expected future marginal product of capital, MPK f , is the
benefit from increasing investment today by one unit of capital.

Thus the benefit of an additional unit of capital is the value of

additional goods or services he produces, MRPK = P × MPK f .

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Investment

The User Cost of Capital

This expected future benefit must be compared to the expected

cost of using that extra unit of capital, or the user cost of capital.

But what is the cost of an additional unit of capital?

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Investment

The User Cost of Capital

The user cost of capital is the expected real cost of using a

unit of capital for a specified period of time.
We consider the expected costs of purchasing a new, say,
machine, using it for a year, and then selling it.

The cost of using the macine, then, has two components,

depreciation and interest:
uc = r ∗ pK + δ ∗ pK
where r is the real interest rate, δ is the depreciation rate and
pK is the cost of capital (machinery, equipment, buildings etc.).

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Investment

The Demand for Capital

Thus, when

MRPK > uc ⇒ invest (install new capital).

MRPK < uc ⇒ disinvest.
MRPK = uc ⇒ optimal investment.

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Investment

The Demand for Capital

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Investment

The Demand for Capital

A change in user cost of capital changes the desired level of
capital.

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Investment

The Demand for Capital

Technological changes that affect the MPK f curve also affect
the desired stock of capital.

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Investment

Desired Capital Stock and Investment

The change in the capital stock during period t, Kt+1 − Kt is

called "net investment".
The capital stock (of a firm or of a country) changes over time
through two opposing channels.
• Through the purchase or construction of new capital
goods, "gross investment" that takes place each year.
• The capital stock depreciates or wears out, which reduces
the capital stock. The amount of depreciation during year t
is δKt , where δ is the fraction of capital that depreciates
each year.

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Investment

Desired Capital Stock and Investment

Hence,
net investment = gross investment − depreciation
Kt+1 − Kt = It − δKt
where

It =gross investment during year t,

Kt =capital stock at the beginning of year t, and
Kt+1 =capital stock at the beginning of year t + 1.

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Investment

Desired Capital Stock and Investment

Rewriting the above equation as
It = Kt+1 − Kt − δKt
which states that gross investment equals net investment plus
depreciation.

Now suppose that firms use information available at the

beginning of year t about the expected future marginal product
of capital and the user cost of capital and determine the desired
capital stock, K ∗ , they want by the end of year t (the beginning
of year t + 1).

Substituting K* for Kt + 1 in the preceding equation yields

It = K ∗ − Kt + δKt .

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