Investment is spending that adds to the capital stock. Investment usually constitutes
about 13 percent of aggregate demand in the United States, but fluctuations
in investment account for a large share of business cycle movements in GDP. We
analyze investment in three categories: business fixed investment, residential
investment, and inventory investment.
The neoclassical theory of business fixed investment sees the rate of investment
being determined by the speed with which firms adjust their capital stocks toward
the desired level. The desired capital stock is bigger the larger the expected output
the firm plans to produce and the smaller the rental or user cost of capital.
The real interest rate is the nominal (stated) interest rate minus the inflation rate.
The rental cost of capital is higher the higher the real interest rate, the lower the
price of the firm’s stock, and the higher the depreciation rate of capital. Taxes also
affect the rental cost of capital, in particular through the investment tax credit. The
investment tax credit is, in effect, a government subsidy for investment.
In practice, firms decide how much to invest using discounted cash flow analysis. This
analysis gives answers that are consistent with those of the neoclassical approach.
The flexible accelerator model of investment illustrates a special case of the
gradual adjustment model of investment.
Because credit is rationed, firms' investment decisions are affected also by the state
of their balance sheets, and thus by the amount of earnings they have retained.
Empirical results show that business fixed investment responds with long lags to
changes in output. The accelerator model, which does not take into account changes
in the rental cost of capital, does almost as good a job of explaining investment as
the more sophisticated neoclassical model.
The theory of housing investment starts from the demand for the stock of housing.
Demand is affected by wealth, the interest rates available on alternative
investments, and the mortgage rate. The price of housing is determined by the
interaction of the stock demand and the fixed stock supply of housing available at
any given time. The rate of housing investment is determined by the rate at which
builders supply housing at the going price.
Housing investment is affected by monetary policy because housing demand is
sensitive to the mortgage interest rate (real and nominal). Credit availability also
plays a role.
Monetary policy and fiscal policy both affect investment, particularly business
fixed investment and housing investment. The effects take place through changes
in real (and nominal, in the case of housing) interest rates and through tax
incentives for investment.
There are substantial lags in the adjustment of investment spending to changes in
output and other determinants of investment. Such lags are likely to increase fluctuations
in GDP.
Inventory investment fluctuates proportionately more than any other class of
investment. Firms have a desired inventory-to-sales ratio. The ratio may get out of
line if sales are unexpectedly high or low, and then firms change their production
levels to adjust inventories. For instance, when aggregate demand falls at the
beginning of a recession, inventories build up. Then when firms cut back production,
output falls even more than did aggregate demand. This is the inventory cycle.
