Principles of Macroeconomics, Chapter 10 Part 1

Chapter 10 Part 1 We have seen that the level of real GDP produced by the economy depends on the quantity of labor employed, holding constant the quantity of capital, other factors of production and the state of technology. Along the aggregate production function, the quantity of capital is fixed. If the quantity of capital increases, the aggregate production function shifts up: with the same quantity of labor employed, the economy is now able to produce more real GDP. In this chapter we study what determines the quantity of capital employed in the economy. Physical capital is the equipment, buildings, machinery, and other durable goods that have already been produced in the past and are used today to produce goods and services. Financial capital is the funds that firms use to purchase physical capital. The quantity of physical capital therefore depends on the quantity of financial capital. Growth of physical capital enables the economy to produce more real GDP over time. Thus, growth of the physical capital stock (together with human capital and technology) is the main engine of economic growth. But growth of physical capital requires growth of financial capital to enable firms to purchase more physical capital. The total quantity of financial capital is determined by the interplay between saving and investment decisions in financial markets. Recall that investment is expenditure by firms on capital goods. Investment expenditures can be on either new capital goods or on additions to inventory. Investment expenditures on new capital goods can be either: Replacement of worn out capital goods, which is called depreciation or Net additions to the stock of capital, which is called net investment. The total amount spent on new capital goods is called gross investment. Thus, Gross investment = Net investment + Depreciation. Therefore, Net investment, which is the change in the stock of capital = Gross investment – Depreciation. Numerical example: A firm’s equipment at the beginning of the year is valued at $10,000. During the year, the market value of this equipment falls by $6,000 (depreciation = $6,000), so that the firm’s existing equipment is worth only $4,000. During the year, the firm spends $8,000 on new equipment (gross investment = $8,000). At the end of the year the firm’s capital is worth $4,000 + $8,000 = $12,000. The value of the firm’s capital has increased from $10,000 at the beginning of the year to $12,000 at the end. Therefore, net investment, defined as the change in the firm’s capital stock, is $2,000. Alternatively: Net investment = Gross investment – Depreciation = $8,000 – $6,000 = $2,000. Investment is financed out of saving – either the firm’s own savings, or by borrowing from other people’s savings. Recall that saving is that portion of income that is not spent on consumption or paid in taxes. Saving means forgoing present consumption in order to attain a higher level of consumption in the future. Wealth is the value of all of the assets that an individual owns. Saving adds to wealth. Wealth also increases when the value of assets rises, which is called capital gains. Thus, ∆Wealth = Saving + Net capital gains In financial markets, or loanable funds markets, borrowers sell bonds or stocks in order to raise funding to finance investment expenditures. Lenders, or savers, buy bonds or stocks, i.e., they make some of their income available to others to spend, and receive interest or dividends as a reward for doing so. A bond is a claim on future income or consumption, i.e., a promise to pay a specified amount of money at a specified date in the future. A stock is an ownership share in a firm that entitles the holder to receive a portion in the firm’s future profits. Investment demand Investment demand is the amount of funds that all firms in the economy plan to spend on investment. The quantity of funds demanded for investment purposes depends on the real interest rate. Other things remaining the same, the higher the real interest rate, the smaller is the quantity of funds demanded for investment spending; and the lower the real interest rate, the greater is the quantity of funds demanded for investment spending. Firms effectively rank different investment projects in declining order in terms of expected rate of profit or rate of return: Thus, for this firm, the investment project with the highest expected rate of return yields a 24% profit. The investment project with the next highest expected rate of return yields 22%, etc. Now, the firm compares these expected rates of profit with the real interest rate. The real interest rate is the opportunity cost of the funds used to purchase the capital goods needed for the investment project. The real interest rate is the opportunity cost of funds whether the firm borrows the funds in the financial market, or uses its own funds, which are called retained earnings. The firm will undertake an investment project only if the expected rate of return on that project is greater than or equal to the real interest rate. If the expected rate of rate of return is less than the real interest rate, the firm will not undertake that investment project, either because the cost of the funds is greater than the profit the firm will obtain from the investment (if the firm is borrowing the funds) or the firm could earn more by lending the funds in the financial market than spending them on the investment project (if the firm is using its own funds). Suppose that the real interest rate is 12%. The firm will undertake all of the investment projects whose expected rate of profit is greater than or equal to 12%. This means that the firm will undertake the first seven investment projects but not the eighth: If the real interest rate were now to decrease to 8%, the number of investment projects that are worthwhile for the firm to undertake will increase. With a real interest rate of 8%, the firm will undertake the first nine investment projects, but not the tenth: This example illustrates that, for an individual firm, the lower the real interest rate, the greater is the number of investment projects that are worthwhile for the firm to undertake. Therefore, the lower the real interest rate, the greater is the quantity of funds demanded for investment purposes. This same inverse relationship between the quantity of funds demanded for investment and the real interest rate holds true, not only for an individual firm, but for all of the firms in the economy. For the whole economy, the relationship between the quantity of funds demanded for investment and the real interest rate, holding everything else constant, is called investment demand: In this example, if the real interest rate decreases from 5% to 4%, the quantity of funds demanded for investment increases from $6 trillion to $7 trillion. This is a movement down along the investment demand curve. Vice versa, if the real interest rate increases from 4% to 5%, the quantity of funds demanded for investment decreases from $7 trillion to $6 trillion. This is a movement up along the investment demand curve. Shifts of investment demand When there is a change in the expected rate of profit, investment demand changes, i.e., the investment demand curve shifts. If the expected rate of profit increases, the quantity of funds demanded for investment at any given real interest rate increases; the investment demand curve shifts to the right. If the expected rate of profit decreases, the quantity of funds demanded for investment at any given real interest rate decreases; the investment demand curve shifts to the left.