There are three parts of investment spending: business fixed investment, residential investment, and inventory investment. Factors that determine business fixed investment are the real interest rate, capital depreciation rate, and relative price of capital goods. The rise of the real interest rate is defined as the rise of the capital opportunity cost, therefore the businessmen will reduce their investment. The corporate income tax and the investment tax credit work on the cost of investment. The resident investment depends on the house price, demand for houses, and the current fixed supply. Because the real-interest rate falls, the demand for houses and resident investment increases and then it will rise the house prices. Furthermore, the inventory investment depends on the real interest rate because mostly firms buy goods stocks by taking bank credits.
Keywords: investment, real interest rate, tax, and capital
Investment is an important factor in the economic development in the long run and the short run business cycle. During a recession, mostly goods and services expenditure decreases significantly because of the fall of the investment. The investment term is different from the spending money for consuming. Spending money for the consumptions of goods and services gives us the utility straight away, however, spending money for investment will give us the higher standard of living in the later on. Furthermore, in the neoclassical and exogenous growth model, both count the investment as one of the main factors that can boost the economic growth. This paper focuses on the explanation of the theories behind of investments function, I=I (r). According to the IS-LM model, the decrease of the real interest rate will increase the spending money for the investment.
Furthermore, Mankiw (2009) categorized the investment spending into three types described below.
1. Business Fixed Investment (equipment and structures in production)
2. Residential Investment (new housing to live and to rent out)
3. Inventory Investment (goods in storage)
Business fixed investment is the goods and services that are bought by the firms for future production in the long term. It is different to the inventory goods that will be sold in the short run. According to many economists, the model Cobb-Douglass production function can explain well about how capital and labor turn into goods and services.
where, A= parameter of technology, K =Capital and L = Labor. In addition, the factors that influence the cost of the capitals are the interest rate, the price of the capital, the depreciation of the capital and the changing rates of capital prices.
Of course, the profit is the main factor of the determinants to increase and decrease the capital stock, can be seen in the function below.
then the investment function,
This function shows that the cost of the capital is influenced by the real interest rate. The higher interest rate means the higher capital cost. So the people tend to reduce to own capital or to reduce the investment. It can be seen in figure 1, panel a below. Furthermore, panel b shows that the shift of the investment function because of the increase of marginal product of capital that will increase the profitability of investment such as the new technology invention.
Figure 1. The Investment Function
Note. Reprinted from Macroeconomics (7th ed.) by Mankiw, N. G., 2009, p. 531. Copyright 2009 by Worth Publishers. Reprinted with permission.
The government policies can also influence the increase or the decrease of the investment through taxes.
a. The corporate income tax (tax on the firm profits)
b. The investment tax credit (tax cuts to stimulate the investment)
Furthermore, the Nobel Prize-winning economist, James Tobin, proposed a new model that is,
If the q>1 means that the firms can raise the value of their firm stocks by investing new capital. The increase of q also means investors’ optimism in the current and future profitability of capital. Mankiw also explains why the stock prices are related to the economic condition. The stock is part of household wealth and the raise of the stock prices reflects the better technological progress and long-run economic growth. Furthermore, other theories of the stock market are the Efficient Market Hypothesis which mainly talks about the value of the asset (stock price) is reflected by all available information and Keynes’ Beauty Contest that fundamentally explains that the stock price reflects the irrational waves of optimism and pessimisms (animal spirits of investors).
Secondly, residential investment is the purchase of the houses by the residents to live in or to rent out. In the panel a, the relative price of housing is determined by the demand and the supply for the stock of houses—the supply of houses is fixed (vertical). The demand curve that slopes downward means that the higher prices of the house make people to share or to be homeless. In panel b shows the supply of the new houses, slopes upward, because the higher price relative will increase to build new houses. Factors that influence the shift of the demand curve are the fall in the real interest rate and population addition.
Figure 2. Housing Market
Note. Reprinted from Macroeconomics (7th ed.) by Mankiw, N. G., 2009, p. 541. Copyright 2009 by Worth Publishers. Reprinted with permission.
Finally, inventory investment is that the firms’ goods that are in storage that will be sold. Mostly it is the smallest part of the money spending around 1% of the GDP. Several reasons for holding inventories are to adjust the level of production overtime, anticipating the low and high sales, and to achieve the efficient operating. For example, in the long Christmas holiday, mostly the firms increase the inventories to prevent running out of the goods (stock-out avoidance). Furthermore, the real interest rate also affects the holding of inventories. When the real interest rate is higher, the businessmen tend to decrease the inventories vice versa. The credit condition also influences the inventories because many firms take credits to buy stocks.
In sum, the real interest rate significantly influences the investment spending. Higher real interest rate means higher cost of capital or higher cost of borrowing houses. The advance of technology and the growth of population shift up the investment of homes and capital. In addition, the output of the economy also influences the number of investment. Higher incomes push the increase in investment spending.
Mankiw, N. G. (2009). Macroeconomics (7th ed.). New York: Worth Publishers.