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Chapter 16
The Economics
of Investment
Behavior
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The Historical Instability of
Investment
• Recall: Gross Domestic Private Investment
(GDPI) includes spending on plant, equipment,
inventories, and housing.
• Historically investment has been more volatile than
consumption spending.
– In the 1973-75 recession, GDPI fell 31%.
– In the subsequent boom, GDPI grew by 46%.
– In the 1981-82 recession, fell 26%.
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The Components of GDPI
• GDPI is divided into two main parts, which also have
subcomponents as follows:
– Fixed Investment
• Residential
• Nonresidential
– Nonresidential Structures
– Producers’ Durable Equipment
– Inventory Change
• The behavior of the three major components of GDPI is shown
in Figure 16-1 and summarized below:
– Residential investment turns early.
– Inventor change exhibits sharp but short-lived swings.
– Fixed nonresidential investment has soared in size.
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Figure 16-1 Real Gross Private Domestic
Investment and Its Four Components, 1960–
2010
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The Accelerator Hypothesis
• The Accelerator Hypothesis states that
the level of net investment depends on the
change in expected output.
• Firms attempt to maintain a fixed ratio of
their stock of capital to their expected
sales (Ye).
– Expected sales are assumed to be estimated
using adaptive expectations:
Y  Y  j (Y1  Y )
e
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e
1
e
1
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The Accelerator Hypothesis (cont.)
• The accelerator hypothesis assumes that the desired stock
of capital (K*) is a multiple of expected sales:
K* = v*Ye
• Net investment is the change in the capital stock:
In = ∆K = K – K-1
Assuming that capital is acquired quickly,
In = K* - K*-1  In = v*∆Ye
• When there is an acceleration in business and expected
output increases, net investment is positive.
– If expect output stops increasing, In falls to zero.
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Table 16-1 Workings of the Accelerator
Hypothesis of Investment for the Hypothetical
Mammoth Electric Company
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Figure 16-2 The Behavior of Actual Sales, Expected Sales,
Gross Investment, Net Investment, and Replacement
Investment for the Mammoth Electric Company Described in
Table 16-1
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Investment and Real GDP
• The relationship between I and GDP is the same as
between In and Ye according to the accelerator
hypothesis.
– In the special case where expected sales are always set
exactly equal to last period’s actual sales:
In = v*∆Y-1
• This simplest form of the accelerator theory was invented by
J.M. Clark in 1917.
– According to this theory, investment is inherently unstable
since any temporary change in output could lead to a
significant change in investment spending.
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Assessing the Simple Accelerator
• There are three main problems with the simple
accelerator theory based on historical U.S. data:
– In does not respond instantaneously to changes in output
growth, but rather displays noticeable lags.
– These lags are not uniform in length, not does In respond to
changes in real GDP growth with uniform speed.
– The In/Y does not have a consistent relationship to real GDP
growth.
• Further, despite the investment boom of the late 1990s, the
overall average level of In/Y was substantially lower than before
1990.
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Figure 16-3 The Relation of the Net Investment Ratio
(In/Y) to the Growth Rate of Real GDP (Y/Y) in the U.S.
Economy, 1960–2010
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The Flexible Accelerator
• The Flexible Accelerator theory of investment loosens several
assumptions of the simple accelerator theory:
– Instead of assuming Ye = Y-1 , the flexible accelerator theory
allows for adaptive expectations.
– The flexible accelerator theory no longer assumes that v* is
constant.
– Capital formation is no longer assumed instantaneous.
• Determinants of gross investment
– The fraction of the gap between K* and last period’s actual capital
that can be closed in a single period.
– The response of Ye to last period’s error in estimating actual
output.
– The proportion of the capital stock that is replaced each year.
– The desired ratio of capital to expected output (v*).
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The Neoclassical Theory of
Investment
• In the 1960s, Harvard’s Dale Jorgenson showed that
the user cost of capital could be derived from
neoclassical microeconomic theory.
• An extra unit of capital will be purchased if the
expected Marginal Product of Capital (MPK) is at
greater than or equal to the User Cost of Capital
(u): MPK ≥ u
– MPK is the extra output that a firm can produce by
adding an extra unit of capital.
– u is the cost to the firm of using a piece of capital for
a specified period.
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Policies to Affect u
• The user cost of capital (u) depends on several
factors:
– An interest cost is involved in buying a capital good.
– Physical deterioration lessens the production ability of
every capital good; in addition some capital goods become
obsolete.
• The Depreciation Rate is the annual percentage decline in
the value of a capital good due to physical deterioration and
obsolescence.
– The interest and depreciation cost are adjusted by price
changes for capital goods.
• Monetary and fiscal policies that lower the interest
rate will lower u and therefore increase I.
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Figure 16-4 The Effect of a Drop
in the User Cost of Capital (u) on the Desired
Capital-Output Ratio (v *)
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Taxation and Investment
• Fiscal policy can also affect the user cost of capital
directly via taxes:
– A higher tax on firms’ profits will raise the effective user cost
of capital for firms.
– Firms can cut their corporate income tax by deducting the
value of depreciation of plant and equipment, so the
government can affect investment by liberalizing or
tightening tax laws.
– During most of the 1962-86 period, a substantial part of
investment in the U.S. was eligible for an investment tax
credit.
• Typically the tax credit would allow firms to deduct 10% of the
value of their equipment investment from their corporate
income taxes.
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Investment in the Great Depression and
World War II
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International Perspective The Level and
Variability of Investment Around the World
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Figure 16-5 Effect on Output and the Interest
Rate of a Shift in the Level of Investment
Relative to the Interest Rate
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