ECON 1113 1st Edition Lecture 20 Outline of Last Lecture I. The Quantity Theory of Deflation: 1865-1896A. The Gold StandardB. Economic Effects of DeflationC. The Free Silver MovementD. The Wizard of Oz as a Monetary AllegoryOutline of Current Lecture I. Investment Spending (I)A. A DefinitionB. Investment Spending and the Business CycleC. Three Types of InvestmentD. Business Fixed Investment (IBF) ModelE. The Expected Rate of Return (ρ) vs. Interest Rate (i)Current LectureI. Investment Spending (I)A. A Definition1. Spending on new capital goodsB. Investment Spending and the Business Cycle1. Highly correlated with “ups and downs” in the business cycle2. Increases during economic expansions and decreases during economic contractions (recessions)C. Three Types of Investment1. Business Fixed Investment (IBF): firms spending on new equipment and new structures used in production2. Residential Investment (IR): spending on new residences, either owner-occupied homes or rental residences (apartments, hotels)3. Inventory Investment (IN): firm spending on goods placed in inventorya. Most highly correlated with the business cycle of the three types of investment4. I = IBF + IR + IN D. Business Fixed Investment (IBF) Model1. Expected rate of return (ρ) vs. interest rate (i)2. Expected rate of return: net revenues expected to flow from a new capitalgood/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% = ρb. But expected revenues are not certain3. Interest rate: opportunity cost of funds invested in new capital goodsa. Can be an explicit cost of funds if the funds are borrowedb. 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 bond4. Decision Rulea. If ρ > i, the firm ought to invest (by the new capital)b. If ρ < i, the firm should not investc.ρ: benefits and i: costs, thus benefits should outweigh costs5. Examplea. XYZ Motor Freight Firmb. Capital spending projects comparisonProjectsNew OfficeBuildingNew LoadingDockNew Car Fleet for SalesPersonnelCapital Goods’Prices$1 million $1/2 million $1/10 millionρ5% 4% 1%i 3% 3% 3%Approval YES YES NOc. Diagrami. Vertical axis: interest rate (i) in percentii. Horizontal axis: business fixed investment (money spent onnew capital goods) in dollarsiii. An inverse relationship ship emerges between I and IBF through the decreasing curve the data formsiv. This curve is known as the “marginal efficiency of investment schedule” or the MEI, which is an investment demand scheduleE. The Expected Rate of Return (ρ) vs. Interest Rate (i)1. Determinants of Investment Spendinga. Interest Rate (i)i. Changes shown in movements along the MEIb. Technologyi. Changes shown by shifts of the entire MEIii. 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 rightiv. Technological problems would have the opposite effectv. 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 exampleso 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 MEIii. Optimistic: expecting better future business conditions (bull market), in which the MEI shifts to the rightiii. Pessimistic: expecting worse future conditions (bear market), in which the MEI shifts to the leftiv. Keynes referred to these as animal