ECON 1113 1st Edition Lecture 20 Outline of Last Lecture I The Quantity Theory of Deflation 1865 1896 A The Gold Standard B Economic Effects of Deflation C The Free Silver Movement D The Wizard of Oz as a Monetary Allegory Outline of Current Lecture I Investment Spending I A A Definition B Investment Spending and the Business Cycle C Three Types of Investment D Business Fixed Investment IBF Model E The Expected Rate of Return vs Interest Rate i Current Lecture I Investment Spending I A A Definition 1 Spending on new capital goods B Investment Spending and the Business Cycle 1 Highly correlated with ups and downs in the business cycle 2 Increases during economic expansions and decreases during economic contractions recessions C Three Types of Investment 1 Business Fixed Investment IBF firms spending on new equipment and new structures used in production 2 Residential Investment IR spending on new residences either owneroccupied homes or rental residences apartments hotels 3 Inventory Investment IN firm spending on goods placed in inventory a Most highly correlated with the business cycle of the three types of investment 4 I IBF IR IN D Business Fixed Investment IBF Model 1 Expected rate of return vs interest rate i 2 Expected rate of return net revenues expected to flow from a new capital good capital good s price These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute a Example 1000 10000 10 b But expected revenues are not certain 3 Interest rate opportunity cost of funds invested in new capital goods a Can be an explicit cost of funds if the funds are borrowed b Can be an implicit cost relevant even if no funds are borrowed retained earnings used to finance the new capital i Used to buy new capital goods or an interest bearing asset such as a bond 4 Decision Rule a If i the firm ought to invest by the new capital b If i the firm should not invest benefits and i costs thus benefits should outweigh costs c 5 Example a XYZ Motor Freight Firm b Capital spending projects comparison Projects New Office Building New Loading Dock New Car Fleet for Sales Personnel Capital Goods Prices 1 million 1 2 million 1 10 million 5 4 1 i 3 3 3 Approval YES YES NO c Diagram i Vertical axis interest rate i in percent ii Horizontal axis business fixed investment money spent on new capital goods in dollars iii An inverse relationship ship emerges between I and IBF through the decreasing curve the data forms iv This curve is known as the marginal efficiency of investment schedule or the MEI which is an investment demand schedule E The Expected Rate of Return vs Interest Rate i 1 Determinants of Investment Spending a Interest Rate i i Changes shown in movements along the MEI b Technology i Changes shown by shifts of the entire MEI ii Suppose technology improves implying that the expected rates of return o the advanced capital goods are higher at all interest rates iii This causes a shift in the MEI toward the right iv Technological problems would have the opposite effect v Schumpeter s Theory of Economic Growth Economic growth occurs in waves of technological innovation which lead to increases in I capital goods and future economic growth Historical examples o 1830s canals 1850s and 1870s again railroads Early 1900s automobiles 1965 microelectronic circuit chip c Investor Expectations about Future Business Conditions investor psychology i Changes shown by shifts of the entire MEI ii Optimistic expecting better future business conditions bull market in which the MEI shifts to the right iii Pessimistic expecting worse future conditions bear market in which the MEI shifts to the left iv Keynes referred to these as animal spirits
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