Investment is of interest because (a) it is the most variable component of GDP and (b) it contributes to economic growth.
gross private domestic investment in 1996 = $116.5 billion
business fixed investment = $781.4 billion
residential investment = $309.2 billion
inventory investment = $25.9 billion
Business fixed investment is the purchase of capital goods by the private sector. In the neoclassical model, the level of fixed investment is determined by the speed with which firms adjust their actual capital stock to their desired capital stock and by the rental cost of capital. The rental cost of capital is the cost of using one more unit of capital in production.
Investment is undertaken for future production. Therefore, it is expected output that determines the desired capital stock.
a rise in the level of expected output increases the desired level of the capital stock
a fall in the rental cost of capital increases the desired level of the capital stock
In equilibrium, the desired level of the capital stock is the level at which the value of the marginal product of capital = rental cost of capital.
The rental cost of capital (rc) is equal to the real interest rate plus the rate of depreciation. rc is also affected by investment tax credits and the corporate tax rate.
effect of fiscal and monetary policy on fixed investment
accelerator model
discounted cash flow analysis
The existing housing stock is large and investment in new housing adds only a small fraction to it. So, the supply of housing curve is vertical. This implies that net investment in housing is zero.
The demand for housing is a function of
mortgage rates (negative)
yields on alternative investments (negative)
wealth (positive)
Inventory investment arises because firms cannot always match the level of production to the level of sales. Inventory investment fluctuates more than the other two categories of investment.
desired versus undesired changes