Download Chapter 5. Investment

Chapter 5
Investment and Saving
Equivalence of Saving and
Investment
• One of the key relationships in the NIPA
balance is that investment must always be
equal to saving on an ex post basis, even
though they may be quite different on an
ex ante basis.
• This is not merely an accounting identity,
but is at the heart of understanding how
the economy functions.
An ex ante rise in investment
• Suppose firms decide to invest more, but
consumer saving patterns are unchanged and
profits have not risen. Where do firms get the
extra money?
• They borrow it by offering higher interest rates.
When that happens, consumers save more.
Also, that is likely to attract more foreign saving.
The increase in investment plans boosts real
GDP and increases government saving. Also,
when interest rates rise, some firms decide to
postpone their purchase of capital goods.
• On an ex post basis, S and I balance.
An ex ante rise in saving
• Now suppose consumers become worried about the
future, so they spend less and save more. However,
these same factors also apply to businesses, which
become more pessimistic and invest less. Yet on an ex
post basis, the change in I and S must be equivalent.
• Interest rates will probably decline in consumers decide
to save more, but in a recessionary environment that
may not stimulate investment.
• The recession will reduce government saving, and less
foreign saving will be attracted. But sometimes even
these adjustments are not sufficient.
• When consumers cut back on spending, income will fall
and unemployment will rise. Thus while consumers plan
to save more, they actually end up saving less.
Reversing the Recession
• When that happens, monetary and fiscal
policy are likely to ease, which will reduce
interest rates further, hence stimulating
consumption and investment.
• If that is insufficient, the recession may
continue indefinitely.
• Most of the time, business cycle
fluctuations are caused by ex ante shifts in
investment rather than saving.
Determinants of Capital Stock
• Firm wants to maximize its expected real rate of
return on investment.
• It will increase capital stock when it thinks the
rate of return on that investment will be higher
than the rate of return that can be earned from
alternative use of those funds.
• Thus investment will be negatively correlated
with the cost of funds, part of which is the rate of
interest. Other factors include the rate of
depreciation and various tax laws.
Factors Affecting the Expected
Rate of Return
• Firms will expect the rate of return on
investment to be higher if output is likely to
increase.
• They are also more likely to invest if
existing capital stock is fully utilized, and
less likely if they already have excess
capacity.
• Firms are more likely to buy new
equipment to replace old if technology has
advanced rapidly.
Availability of Credit
• Large firms can always borrow funds in
capital markets. But some investment is
undertaken by firms that cannot borrow as
much as desired.
• For those firms, credit availability is also
an important factor.
• Also, some firms rely on equity financing,
so the price/earnings ratio of the stock
market is also important.
Expectations
• Output, capacity utilization, interest rates,
availability of credit, the stock market, and tax
laws are all important determinants of
investment. Yet because most capital spending
will remain in service for many years,
expectations about the future are paramount.
• Whereas unusually low interest rates and
greater credit availability will almost always
stimulate consumer spending, they will not boost
investment if firms think the additional equipment
will simply remain idle.
Expectations (Slide 2)
• No one has yet figured out how to measure
expectations precisely, and no economist has
yet figured out how to predict them.
• However, the best available measure we have of
business expectations is the stock market.
• As a result, the stock market is an important
determinant of capital spending for several
reasons: cost of capital, availability of capital for
firms that cannot borrow very much, and as a
measure of expectations
• The stock market has a much greater impact on
investment than consumption.
Lags in Capital Spending
• Unlike consumers, who often purchase
goods and services without any delay,
planning for capital expenditures usually
involves a substantial time delay.
• Even after the goods are ordered, it may
be several months or even years (large
aircraft) before they are delivered.
• As a result, capital spending generally lags
the business cycle.
Tax Policy
• In the post World War II period, many
attempts have been made to adjust fiscal
policy to affect capital spending.
• Some have been designed to increase the
long-term ratio of capital spending to GDP
• Some have been designed to boost
investment during recessions and reduce
it during periods of overfull employment.
Implements of Tax Policy
• The major methods used to achieve these goals
have been:
• Adjusting the rate of investment tax credit
• Adjusting depreciation schedules by allowing
faster (or slower) writeoffs.
• Changing the statutory corporate income tax
rate.
• Reducing the tax rate on capital gains or
dividends, hence boosting the stock market
Do They Work?
• These tools have remained controversial,
not only among liberals who think
businesses already receive too many tax
breaks, but among business leaders
themselves, many of whom claim that
investment decisions are made
independent of tax considerations.
Do They Work (Slide 2)
• Economists generally agree that any tax break
to stimulate investment will be partially offset by
the increase in the government deficit, which
may raise interest rates or “crowd out” private
sector investment.
• This is far less likely to happen when the
economy is in recession and there is excess
liquidity. But it is precisely at those times that
investment is least likely to be boosted by
stimulative tax policy.
Do They Work (Slide 3)
• A review of the past 50 years suggests that
changes in policy have had some short-term
impact on capital spending, but probably have
not changed the long-term ratio of capital
spending to GDP very much.
• In particular, the cancellation of the investment
tax credit in 1986 was followed by a temporary
dip in capital spending, but capital spending
soared during the 1990s because of improved
expectations and faster growth in technology.
Other Determinants of Saving
• So far we have discussed consumer saving and
capital spending. Two other key determinants of
the saving = investment identity are:
• Foreign saving
• Government saving
• Foreign saving is essentially equal to the trade
balance with the opposite sign. The greater our
trade deficit, for example, the greater foreign
saving will be. This is true for the U.S. because
the world is on a de facto dollar standard; that
relationship does not necessarily hold for
smaller countries.
The Twin Deficits
• During the 1980s, economists used to talk about the
“twin deficits” – the Federal budget deficit and the trade
deficit. Since the trade deficit is equal to foreign saving,
essentially foreign investors paid for our deficit.
• Thus it was sometimes claimed that if the government
deficit declined, so would the trade deficit. Yet in the late
1990s, the government budget moved back into surplus,
while the trade deficit rose faster than ever. In this case,
foreign investors paid for our investment boom without
consumers having to save more.
• In the 2001 recession, investment dropped sharply, but
foreign saving did not. Instead, it shifted back to paying
for the government deficit.
Economic Impact of the Trade
Deficit
• The “twin deficit” issue is mentioned prominently
to emphasize that a trade deficit is not
necessarily bad for the economy.
• According to the fundamental identity
C + I + G + F = GDP, a decline in net exports
must necessarily reduce GDP. But that is not
true. If F declines, the resulting increase in
foreign saving may boost I.
• In addition, the net export balance is
countercyclical, falling in booms and rising in
recessions. That moderate recessions and also
helps to keep the economy from overheating
Determinants of Exports
• Foreign demand
• Trade-weighted average value of the
dollar, usually lagged about one year
• For the U.S., the Repercussion Effect.
When the U.S. economy booms, our
imports rise, which means exports of other
countries rise – so they can buy more
exports from the U.S. The usual lag for
this term is also about one year.
Determinants of Imports
• Domestic Demand
• Value of the dollar, although that is not as
important for imports as for exports,
because most foreign countries adjust
their prices to U.S. levels.
• Capacity utilization: when bottlenecks
occur in domestic production, imports rise
more rapidly.
Government Saving
• The government saving rate is highly correlated
with the growth rate.
• In general, every 1% change in the growth rate
changes the ratio of the government budget
surplus or deficit to GDP by about ½%.
• Thus, for example, if real growth fell from +4% to
-2% (a typical recession) and the budget had
been in balance, the deficit would rise to 3% of
GDP (about $300 billion) even if no changes
were made in spending programs or tax rates.
Deficits – Good or Bad?
• The political party in opposition – no matter
which one – invariably jumps on this deficit
figure as a sign of fiscal mismanagement.
• Yet in fact it is an important positive
development. Without this massive decline in
government saving, saving and investment
could be balanced only at the cost of a much
more severe and long-lasting recession.
Deficits – Good or Bad (Slide 2)
• Most economists agree that the Federal
budget should be balanced over the
business cycle. It should be in deficit
during recessions, and in surplus during
periods of full employment.
• Keeping the budget in deficit during the
entire cycle generally crowds out private
sector investment and hence reduces the
long-term growth rate.