Shifts of the Investment Demand Curve

Shifts of the Investment Demand Curve Figure 30.5 shows the relation between the interest rate and the amount of investment demanded, other things equal. When other things change, the investment demand curve shifts. o In general, any factor that leads businesses collectively to expect greater rates of return on their investments increases investment demand. That factor shifts the investment demand curve to the right. Any factor that leads businesses collectively to expect lower rates of return on their investments shifts the curve to the left. What are those non-interest-rate determinants of investment demand? o Acquisition, maintenance, and operating costs The initial costs of capital goods, and the estimated costs of operating and maintaining those items, affect the expected rate of return on investment. When these costs rise, the expected rate of return from prospective investment projects falls, and the investment demand curve shifts to the left. o Example: Higher electricity costs associated with operating tolls and machinery shift the investment demand curve to the left. Lower costs shift it to the right. o Business taxes  Firms look to expected returns after taxes in making their investment decisions. An increase in business taxes lowers the expected profitability of investments and shifts the investment demand curve to the left; a reduction of business taxes shifts it to the right. o Technological change  Technological progress – the development of new products, improvements in existing products, and the creation of new machinery and production processes – stimulates investment.  The development of a more efficient machine, for example, lowers production costs or improves product quality and increases the expected rate of return from investigating in the machine.  Profitable new products (cholesterol medications, flying drones, self-driving cars, and so on) induce a flurry of investment as businesses tool up for expanded production.  A rapid rate of technological progress shifts the investment demand curve to the right. o Stock of capital goods on hand  The stock of capital goods on hand relative to output and sales, influences firms’ investment decisions. When the economy is overstocked with production facilities and when firms have excessive inventories of finished goods, the expected rate of return on new investment declines. o Firms with excess production capacity have little incentive to invest in new capital.  Therefore, less investment is forthcoming at each real interest rate; the investment in forthcoming at each real interest rate; the investment demand curve shifts leftward. When the economy is understocked with production facilities and when firms are selling their output as fast as they can produce it, the expected rate of return on new investment increases, and the investment demand curve shifts rightward. o Planned inventory changes  Recall from Chapter 27 that the definition of investment includes changes in inventories of unsold goods. An increase in inventories is a positive investment while a decrease in inventories is a negative investment. It is important to remember that some inventory changes are planned, while others are unplanned. o Because the investment demand curve shows only planned investment, it is affected only by planned changes in firms’ inventory levels.   If firms plan to increase their inventories, the investment demand curve shifts to the right.  If the firms plan to decrease their inventories, the investment demand curve shifts to the left. Firms make planned changes to their inventory levels mostly because they expect either faster or slower sales. A firm that expects its sales to double next year will want to keep more inventory in stock, thereby increasing its investment demand. o By contrast, a firm that is expecting slower sales will plan to reduce its inventory, thereby reducing its overall investment demand.  But because life often does not turn out as expected, firms often find that the actual amount of inventory investment that they end up making is either more or less than what they had planned.  The size of the gap is the dollar amount of unplanned inventory changes. o Expectations  Most capital goods are durable, with a life expectancy of 10 or 20 years. Thus, the expected rate of return on capital investment depends on the firm’s expectations of future sales, future operating costs, and future profitability of the product that the capital helps produce. o These expectations are based on forecasts of future business conditions as well as on difficultto-predict factors, such as changes in the domestic political climate, executives become more optimistic about future sales, costs, and profits, the investment demand curve will shift to the right; a pessimistic outlook will shift the curve to the left. Instability of Investment  Unlike consumption, investment is unstable; its rises and falls quite often. o In fact, investment is the most volatile component of total spending – so much so that most fluctuations in output and employment result from demand shocks relating to unexpected increases and decreases in investment.  Several interrelated factors explain the variability of investment. Variability of Expectations o Business expectations can change very quickly when some event suggests a significant possible change in future business conditions.  Changes in exchange rates, trade barriers, legislative actions, stock market prices, government economic policies, the outlook for war or peace, court decisions in key labor or antitrust cases, and a host of other considerations may substantially shift business expectations. Durability o Within limits, purchases of capital goods are discretionary and therefore can be postponed.  Firms can scrap or replace older equipment and buildings, or they can patch them up and use them for a few more years. Optimism about the future may prompt firms to replace their older facilities, and such modernizing will call for a high level of investment. o A less optimistic view, however, may lead to smaller amounts of investment as firms repaid older facilities and keep them in use. Irregularity of Innovation o New products and processes stimulate investment.  Major innovations such as electricity, airplanes, automobiles, computers, and smartphones induce vast upsurges or “waves” of investment spending that in time recede. But such innovations occur quite irregularly, adding to the volatility of investment. Variability of Profits o High current profits often generate optimism about the future profitability of new investments, whereas low current profits or losses spawn considerable doubt about the wisdom of new investments.  Additionally, firms often save a portion of current profits as retained earnings and use these funds (as well as borrowed funds) to finance new investments. So current profits affect both the incentive and ability to invest. So current profits themselves are highly variable from year to year, contributing to the volatility of investment.  The volatility of investment causes occasional and substantial unexpected shifts of the investment demand curve, which in turn generate significant changes in investment spending. o These demand shocks can contribute to cyclical instability. The Multiplier Effect  Assuming that the economy has room to expand – so that increases in spending do not lead to increases in prices – there is a direct (positive) relationship between change in spending and changes in real GDP. More spending results in a higher real GDP; less spending results in a lower real GDP.  But there is much more to the relationship between these two aggregates. o As an example, note that an initial change in investment spending can change output and income by a larger amount (that is, by an amount larger than the initial change in investment spending).   That surprising result is called the multiplier effect: any initial change in a component of total spending can lead to a larger change in GDP. The number known as the multiplier determines how much larger that change will be; it is the ratio of the change in GDP to the initial change in spending (in this case, investment). o Stated algebraically.  Multiplier = change in real GDP / initial change in spending By rearranging this equation, we can also say that the change in real GDP = multiplier X initial change in spending.  Note these three points about the multiplier: o The “initial change in spending” is usually associated with investment spending.  But changes in consumption (unrelated to changes in income), net exports, and government purchases can also generate multiplier effects. o The “initial change in spending” associated with investment spending results from a change in the real interest rate and/or a shift of the investment demand curve. o The multiplier works in both directions.  An initial increase in spending will create a “multiplied” increase in GDP, while an initial decrease in spending will create a “multiplied” decrease in GDP. Rationale  The multiplier effect follows from two facts. o First, the economy supports a continuous flow of expenditures and income through which dollars spent by Lee are received as income by Okafor and then spent by Okafor and received as income by Gonzales and so on. o Second, any change in income changes both consumption and saving in the same direction as, and by a constant fraction of the change in income.  It follows that an initial change in spending will start a “spending chain” throughout the economy – a change in which each successive link is fractionally smaller than the previous link. o That chain of spending will multiply the initial change in GDP.  As a result, any initial change in spending will produce a magnified change in output and income. The Multiplier and the Marginal Propensities  You may have sensed from the table in Figure 30.7 that the fraction of any increase in income that is consumed (MPC) or saved (MPS) determines the size of the multiplier. o That is true because the value of the MPC or MPS determines the size of each of the successive rounds of spending caused by any initial change in spending.   The larger the MPC (smaller the MPS), the larger each successive round will be.  The smaller the MPC) the larger the MPS), the smaller each successive round will be. The MPC and the multiplier are directly related, while the MPS and the multiplier are inversely related. o The formulas that summarize these multiplier relationships are presented in the next two equations.  The first equation presents the multiplier as a function of MPC: Multiplier = 1 / 1 – MPC  To understand the second equation, which presents the multiplier as a function of MPS, recall that MPC + MPS = 1. Therefore MPS = 1 – MPC, which means we can also write the multiplier formula as o Multiplier = 1 / MPS  This version of the multiplier formula indicated that the multiplier varies inversely with the MPS, so that a larger MPS implies a smaller multiplier, and vice versa.  You can verify this inverse relationship for yourself by substituting particular MPS values into the formula. For instance, when the MPS is 0.25, as in our example, the multiplier is 4. If the MPS were 0.2, the multiplier would be 5. If the MPS were 0.33, the multiplier would be 3.  The intuition behind this inverse relationship between MPS and the multiplier has to do with how changes in the MPS affect the size of each round of the multiplier process. o As we will demonstrate, the smaller the fraction, of any change in income saved (that is, the smaller the MPS), the greater the amount of respending at each round and, therefore, the greater the multiplier.  We can summarize these results in terms of MPC. o A large MPC (small MPS) means the succeeding rounds of consumption spending shown in Figure 30.7 diminish slowly and thereby cumulate to a large total change in income.