Chapter 14 Investment and Economic Activity

Components of Investment

Additions to the stock of private capital are called Gross Private Domestic Investment (GPDI). GPDI includes four categories of investment:

1. Nonresidential Structures. This category of investment includes the construction of business structures such as private office buildings, warehouses, factories, private hospitals and universities, and other structures in which the production of goods and services takes place. A structure is counted as GPDI only during the period in which it is built. It may be sold several times after being built, but such sales are not counted as investment. Recall that investment is part of GDP, and GDP is the value of production in any period, not total sales.
2. Nonresidential Equipment and Software. Producers’ equipment includes computers and software, machinery, computers, trucks, cars, and desks, that is, any business equipment that is expected to last more than a year. Equipment and software are counted as investment only in the period in which it is produced.
3. Residential Investment. This category includes all forms of residential construction, whether apartment houses or single-family homes, as well as residential equipment such as computers and software.
4. Change in Private Inventories. Private inventories are considered part of the nation’s capital stock, because those inventories are used to produce other goods. All private inventories are capital; additions to private inventories are thus investment. When private inventories fall, that is recorded as negative investment.

Figure 14.1 "Components of Gross Private Domestic Investment, 1995–2010" shows the components of gross private domestic investment from 1995 through 2010. We see that producers’ equipment and software constitute the largest component of GPDI in the United States. Residential investment was the second largest component of GPDI for most of the period shown but it shrank considerably during the 2007-2009 recession.

Figure 14.1 Components of Gross Private Domestic Investment, 1995–2010

This chart shows the levels of each of the four components of gross private domestic investment from 1990 through the third quarter of 2010. Nonresidential equipment and software is the largest component of GPDI and has shown the most substantial growth over the period.

Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised November 23, 2010). Data are through the third quarter of 2010.

Gross and Net Investment

As capital is used, some of it wears out or becomes obsolete; it depreciates (the Commerce Department reports depreciation as “consumption of fixed capital”). Investment adds to the capital stock, and depreciation reduces it. Gross investment minus depreciation is net investment. If gross investment is greater than depreciation in any period, then net investment is positive and the capital stock increases. If gross investment is less than depreciation in any period, then net investment is negative and the capital stock declines.

In the official estimates of total output, gross investment (GPDI) minus depreciation equals net private domestic investment (NPDI). The value for NPDI in any period gives the amount by which the privately held stock of physical capital increased during that period.

Figure 14.2 "Gross Private Domestic Investment, Depreciation, and Net Private Domestic Investment, 1990–2009" reports the real values of GPDI, depreciation, and NPDI from 1990 to 2009. We see that the bulk of GPDI replaces capital that has been depreciated. Notice the sharp reductions in NPDI during the recessions of 1990–1991, 2001, and especially 2007 – 2009.

Figure 14.2 Gross Private Domestic Investment, Depreciation, and Net Private Domestic Investment, 1990–2009

The bulk of gross private domestic investment goes to the replacement of capital that has depreciated, as shown by the experience of the past two decades.

Source: Bureau of Economic Analysis, NIPA Table 5.2.6 (revised August 5, 2010).

The Volatility of Investment

Investment, measured as GPDI, is among the most volatile components of GDP. In percentage terms, year-to-year changes in GPDI are far greater than the year-to-year changes in consumption or government purchases. Net exports are also quite volatile, but they represent a much smaller share of GDP. Figure 14.3 "Changes in Components of Real GDP, 1990–2010" compares annual percentage changes in GPDI, personal consumption, and government purchases. Of course, a dollar change in investment will be a much larger change in percentage terms than a dollar change in consumption, which is the largest component of GDP. But compare investment and government purchases: their shares in GDP are comparable, but investment is clearly more volatile.

Figure 14.3 Changes in Components of Real GDP, 1990–2010

Annual percentage changes in real GPDI have been much greater than annual percentage changes in the real values of personal consumption or government purchases.

Source: Bureau of Economic Analysis, NIPA Table 1.1.1 (revised November 23, 2010). Data are through the third quarter of 2010.

Given that the aggregate demand curve shifts by an amount equal to the multiplier times an initial change in investment, the volatility of investment can cause real GDP to fluctuate in the short run. Downturns in investment may trigger recessions.

Investment, Consumption, and Saving

Earlier we used the production possibilities curve to illustrate how choices are made about investment, consumption, and saving. Because such choices are crucial to understanding how investment affects living standards, it will be useful to reexamine them here.

Figure 14.4 "The Choice between Consumption and Investment" shows a production possibilities curve for an economy that can produce two kinds of goods: consumption goods and investment goods. An economy operating at point A on PPC₁ is using its factors of production fully and efficiently. It is producing C_A units of consumption goods and I_A units of investment each period. Suppose that depreciation equals I_A, so that the quantity of investment each period is just sufficient to replace depreciated capital; net investment equals zero. If there is no change in the labor force, in natural resources, or in technology, the production possibilities curve will remain fixed at PPC₁.

Figure 14.4 The Choice between Consumption and Investment

A society with production possibilities curve PPC₁ could choose to produce at point A, producing C_A consumption goods and investment of I_A. If depreciation equals I_A, then net investment is zero, and the production possibilities curve will not shift, assuming no other determinants of the curve change. By cutting its production of consumption goods and increasing investment to I_B, however, the society can, over time, shift its production possibilities curve out to PPC₂, making it possible to enjoy greater production of consumption goods in the future.

Now suppose decision makers in this economy decide to sacrifice the production of some consumption goods in favor of greater investment. The economy moves to point B on PPC₁. Production of consumption goods falls to C_B, and investment rises to I_B. Assuming depreciation remains I_A, net investment is now positive. As the nation’s capital stock increases, the production possibilities curve shifts outward to PPC₂. Once that shift occurs, it will be possible to select a point such as D on the new production possibilities curve. At this point, consumption equals C_D, and investment equals I_D. By sacrificing consumption early on, the society is able to increase both its consumption and investment in the future. That early reduction in consumption requires an increase in saving.

We see that a movement along the production possibilities curve in the direction of the production of more investment goods and fewer consumption goods allows the production of more of both types of goods in the future.

Case in Point: The Reduction of Private Capital in the Depression

Figure 14.5

Net private domestic investment (NPDI) has been negative during only two periods in the last 70 years. During one period, World War II, massive defense spending forced cutbacks in private sector spending. (Recall that government investment is not counted as part of net private domestic investment in the official accounts; production of defense capital thus is not reflected in these figures.) The other period in which NPDI was negative was the Great Depression.

Aggregate demand plunged during the first four years of the Depression. As firms cut their output in response to reductions in demand, their need for capital fell as well. They reduced their capital by holding gross private domestic investment below depreciation beginning in 1931. That produced negative net private domestic investment; it remained negative until 1936 and became negative again in 1938. In all, firms reduced the private capital stock by more than $529.5 billion (in 2007 dollars) during the period.

Figure 14.6

Interest Rates and Investment

We often hear reports that low interest rates have stimulated housing construction or that high rates have reduced it. Such reports imply a negative relationship between interest rates and investment in residential structures. This relationship applies to all forms of investment: higher interest rates tend to reduce the quantity of investment, while lower interest rates increase it.

To see the relationship between interest rates and investment, suppose you own a small factory and are considering the installation of a solar energy collection system to heat your building. You have determined that the cost of installing the system would be $10,000 and that the system would lower your energy bills by $1,000 per year. To simplify the example, we shall suppose that these savings will continue forever and that the system will never need repair or maintenance. Thus, we need to consider only the $10,000 purchase price and the $1,000 annual savings.

If the system is installed, it will be an addition to the capital stock and will therefore be counted as investment. Should you purchase the system?

Suppose that your business already has the $10,000 on hand. You are considering whether to use the money for the solar energy system or for the purchase of a bond. Your decision to purchase the system or the bond will depend on the interest rate you could earn on the bond.

Putting $10,000 into the solar energy system generates an effective income of $1,000 per year—the saving the system will produce. That is a return of 10% per year. Suppose the bond yields a 12% annual interest. It thus generates interest income of $1,200 per year, enough to pay the $1,000 in heating bills and have $200 left over. At an interest rate of 12%, the bond is the better purchase. If, however, the interest rate on bonds were 8%, then the solar energy system would yield a higher income than the bond. At interest rates below 10%, you will invest in the solar energy system. At interest rates above 10%, you will buy a bond instead. At an interest rate of precisely 10%, it is a toss-up.

If you do not have the $10,000 on hand and would need to borrow the money to purchase the solar energy system, the interest rate still governs your decision. At interest rates below 10%, it makes sense to borrow the money and invest in the system. At interest rates above 10%, it does not.

In effect, the interest rate represents the opportunity cost of putting funds into the solar energy system rather than into a bond. The cost of putting the $10,000 into the system is the interest you would forgo by not purchasing the bond.

At any one time, millions of investment choices hinge on the interest rate. Each decision to invest will make sense at some interest rates but not at others. The higher the interest rate, the fewer potential investments will be justified; the lower the interest rate, the greater the number that will be justified. There is thus a negative relationship between the interest rate and the level of investment.

Figure 14.7 "The Investment Demand Curve" shows an investment demand curveA curve that shows the quantity of investment demanded at each interest rate, with all other determinants of investment unchanged. for the economy—a curve that shows the quantity of investment demanded at each interest rate, with all other determinants of investment unchanged. At an interest rate of 8%, the level of investment is $950 billion per year at point A. At a lower interest rate of 6%, the investment demand curve shows that the quantity of investment demanded will rise to $1,000 billion per year at point B. A reduction in the interest rate thus causes a movement along the investment demand curve.

Figure 14.7 The Investment Demand Curve

The investment demand curve shows the volume of investment spending per year at each interest rate, assuming all other determinants of investment are unchanged. The curve shows that as the interest rate falls, the level of investment per year rises. A reduction in the interest rate from 8% to 6%, for example, would increase investment from $950 billion to $1,000 billion per year, all other determinants of investment unchanged.

Other Determinants of Investment Demand

Perhaps the most important characteristic of the investment demand curve is not its negative slope, but rather the fact that it shifts often. Although investment certainly responds to changes in interest rates, changes in other factors appear to play a more important role in driving investment choices.

This section examines eight additional determinants of investment demand: expectations, the level of economic activity, the stock of capital, capacity utilization, the cost of capital goods, other factor costs, technological change, and public policy. A change in any of these can shift the investment demand curve.

Public Policy

Public policy can have significant effects on the demand for capital. Such policies typically seek to affect the cost of capital to firms. The Kennedy administration introduced two such strategies in the early 1960s. One strategy, accelerated depreciation, allowed firms to depreciate capital assets over a very short period of time. They could report artificially high production costs in the first years of an asset’s life and thus report lower profits and pay lower taxes. Accelerated depreciation did not change the actual rate at which assets depreciated, of course, but it cut tax payments during the early years of the assets’ use and thus reduced the cost of holding capital.

The second strategy was the investment tax credit, which permitted a firm to reduce its tax liability by a percentage of its investment during a period. A firm acquiring new capital could subtract a fraction of its cost—10% under the Kennedy administration’s plan—from the taxes it owed the government. In effect, the government “paid” 10% of the cost of any new capital; the investment tax credit thus reduced the cost of capital for firms.

Though less direct, a third strategy for stimulating investment would be a reduction in taxes on corporate profits (called the corporate income tax). Greater after-tax profits mean that firms can retain a greater portion of any return on an investment.

A fourth measure to encourage greater capital accumulation is a capital gains tax rate that allows gains on assets held during a certain period to be taxed at a different rate than other income. When an asset such as a building is sold for more than its purchase price, the seller of the asset is said to have realized a capital gain. Such a gain could be taxed as income under the personal income tax. Alternatively, it could be taxed at a lower rate reserved exclusively for such gains. A lower capital gains tax rate makes assets subject to the tax more attractive. It thus increases the demand for capital. Congress reduced the capital gains tax rate from 28% to 20% in 1996 and reduced the required holding period in 1998. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the capital gains tax further to 15% and also reduced the tax rate on dividends from 38% to 15%. A proposal to eliminate capital gains taxation for smaller firms was considered but dropped before the stimulus bill of 2009 was enacted.

Accelerated depreciation, the investment tax credit, and lower taxes on corporate profits and capital gains all increase the demand for private physical capital. Public policy can also affect the demands for other forms of capital. The federal government subsidizes state and local government production of transportation, education, and many other facilities to encourage greater investment in public sector capital. For example, the federal government pays 90% of the cost of investment by local government in new buses for public transportation.

Key Takeaways

• The quantity of investment demanded in any period is negatively related to the interest rate. This relationship is illustrated by the investment demand curve.
• A change in the interest rate causes a movement along the investment demand curve. A change in any other determinant of investment causes a shift of the curve.
• The other determinants of investment include expectations, the level of economic activity, the stock of capital, the capacity utilization rate, the cost of capital goods, other factor costs, technological change, and public policy.

Try It!

Show how the investment demand curve would be affected by each of the following:

1. A sharp increase in taxes on profits earned by firms
2. An increase in the minimum wage
3. The expectation that there will be a sharp upsurge in the level of economic activity
4. An increase in the cost of new capital goods
5. An increase in interest rates
6. An increase in the level of economic activity
7. A natural disaster that destroys a significant fraction of the capital stock

Case in Point: Assessing the Impact of a One-Year Tax Break on Investment

Figure 14.8

The U.S. economy was expanding in 2004, but there was a feeling that it still was not functioning as well as it could, as job growth was rather sluggish. To try to spur growth, Congress, supported by President Bush, passed a law in 2004 called the American Jobs Creation Act that gave businesses a one-year special tax break on any profits accumulating overseas that were transferred to the United States. Such profits are called repatriated profits and were estimated at the time to be about $800 billion. For 2005, the tax rate on repatriated profits essentially fell from 25% to 5.25%.

Did the tax break have the desired effect on the economy? To some extent yes, though business also found other uses for the repatriated funds. There were 843 companies that repatriated $312 billion that qualified for the tax break. The Act thus generated about $18 billion in tax revenue, a higher level than had been expected. Some companies announced they were repatriating profits and continuing to downsize. For example, Colgate-Palmolive brought back $800 million and made known it was closing a third of its factories and eliminating 12% of its workforce. However, other companies’ plans seemed more in line with the objectives of the special tax break—to create jobs and spur investment.

For example, spokesman Chuck Mulloy of Intel, which repatriated over $6 billion, said the company was building a $3-billion wafer fabrication facility and spending $345 million on expanding existing facilities. “I can’t say dollar-for-dollar how much of the funding for those comes from off-shore cash,” but he felt that the repatriated funds were contributing to Intel’s overall investments. Spokeswoman Margaret Graham of Bausch and Lomb, which makes eye-care products and repatriated $805 million, said, “We plan to use that cash for capital expenditures, investment in research and development, and paying nonofficer compensation.”

Analysts are skeptical, though, that the repatriated profits really contributed to investment. The New York Times reported on one study that suggested it had not. Rather, the repatriated funds were used for other purposes, such as stock repurchases. The argument is that the companies made investments that they were planning to make and the repatriated funds essentially freed up funding for other purposes.

Sources: Timothy Aeppel, “Tax Break Brings Billion to U.S., But Impact on Hiring Is Unclear,” Wall Street Journal, October 5, 2005, p. A1; Lynnley Browning, “A One-Time Tax Break Saved 843 U.S. Corporations $265 Billion,” New York Times, June 24, 2008, p. C3.

Answers to Try It! Problems

1. The investment demand curve shifts to the left: Panel (b).
2. A higher minimum wage makes labor more expensive. Firms are likely to shift to greater use of capital, so the investment demand curve shifts to the right: Panel (a).
3. The investment demand curve shifts to the right: Panel (a).
4. The investment demand curve shifts to the left: Panel (b).
5. An increase in interest rates causes a movement along the investment demand curve: Panel (c).
6. The investment demand curve shifts to the right: Panel (a).
7. The need to replace capital shifts the investment demand curve to the right: Panel (a).

Figure 14.9

Investment and Aggregate Demand

In the short run, changes in investment cause aggregate demand to change. Consider, for example, the impact of a reduction in the interest rate, given the investment demand curve (ID). In Figure 14.10 "A Change in Investment and Aggregate Demand", Panel (a), which uses the investment demand curve introduced in Figure 14.7 "The Investment Demand Curve", a reduction in the interest rate from 8% to 6% increases investment by $50 billion per year. Assume that the multiplier is 2. With an increase in investment of $50 billion per year and a multiplier of 2, the aggregate demand curve shifts to the right by $100 billion to AD₂ in Panel (b). The quantity of real GDP demanded at each price level thus increases. At a price level of 1.0, for example, the quantity of real GDP demanded rises from $8,000 billion to $8,100 billion per year.

Figure 14.10 A Change in Investment and Aggregate Demand

A reduction in the interest rate from 8% to 6% increases the level of investment by $50 billion per year in Panel (a). With a multiplier of 2, the aggregate demand curve shifts to the right by $100 billion in Panel (b). The total quantity of real GDP demanded increases at each price level. Here, for example, the quantity of real GDP demanded at a price level of 1.0 rises from $8,000 billion per year at point C to $8,100 billion per year at point D.

A reduction in investment would shift the aggregate demand curve to the left by an amount equal to the multiplier times the change in investment.

The relationship between investment and interest rates is one key to the effectiveness of monetary policy to the economy. When the Fed seeks to increase aggregate demand, it purchases bonds. That raises bond prices, reduces interest rates, and stimulates investment and aggregate demand as illustrated in Figure 14.10 "A Change in Investment and Aggregate Demand". When the Fed seeks to decrease aggregate demand, it sells bonds. That lowers bond prices, raises interest rates, and reduces investment and aggregate demand. The extent to which investment responds to a change in interest rates is a crucial factor in how effective monetary policy is.

Investment and Economic Growth

Investment adds to the stock of capital, and the quantity of capital available to an economy is a crucial determinant of its productivity. Investment thus contributes to economic growth. We saw in Figure 14.4 "The Choice between Consumption and Investment" that an increase in an economy’s stock of capital shifts its production possibilities curve outward. (Recall from the chapter on economic growth that it also shifts the economy’s aggregate production function upward.) That also shifts its long-run aggregate supply curve to the right. At the same time, of course, an increase in investment affects aggregate demand, as we saw in Figure 14.10 "A Change in Investment and Aggregate Demand".

Case in Point: Investment by Businesses Saves the Australian Expansion

Figure 14.11

With consumer and export spending faltering in 2005, increased business investment spending seemed to be keeping the Australian economy afloat. “Corporate Australia is solidly behind the steering wheel of the Australian economy,” said Craig James, an economist for Commonwealth Securities, an Australian Internet securities brokerage firm. “The clear message from the latest investment survey is that corporate Australia is flush with cash and ready to spend,” he continued.

The data supported his conclusions. The level of investment spending in Australia on new buildings, plant, and equipment was 17% higher in 2005 than in 2004. Within the investment category, mining investment, spurred on by high prices for natural resources, was particularly strong.

Source: Scott Murdoch, “Equipment Investment Gives Boost to Economy,” Courier Mail (Queensland, Australia), September 2, 2005, Finance section, p. 35.

Answer to Try It! Problem

Panel (a) shows AD shifting by more than LRAS; the price level will rise in the long run.

Panel (b) shows AD and LRAS shifting by equal amounts; the price level will remain unchanged in the long run.

Panel (c) shows LRAS shifting by more than AD; the price level falls in the long run.

Figure 14.12