.(Note that Parkin avoids this issue by using simple examples
with one- year time horizons).
Capital stocks, investment flows, and real interest rates
We saw earlier that the capital stock at any point in time (plant, equipment, buildings, and inventories) is the cumulative outcome of gross investment flows (purchases of new capital) net of depreciation, or net investment. Investment is strongly correlated with the business cycle, rising sharply during expansions and falling sharply during recessions. On average, growth in the capital stock amounts to about 2 percent per year.
Parkin notes that in addition to the privately owned capital stock resulting from private investment (business investment plus investment in new homes and additions to inventories), we also have publicly owned capital stock in the form of social infrastructure (highways, dams, schools). Expenditures on these social investments are treated in the national income accounts simply as part of government expenditures, and not distinguished from other government spending despite their importance in contributing to long-run growth. A number of observers have argued that this approach leads to undervaluation of the importance of federal infrastructure investments.
There are distinct differences across countries in levels of investment relative to GDP. The U.S., with an investment rate typically just under 20 percent (16-22 percent), has tended over the past 20+ years to invest less than other industrialized countries, which presently are investing just over 20 percent of GDP (and with this rate being on a downward trend; over the last 20 years the range has been 26-21 percent). Developing countries as a group have had somewhat higher investment rates (of about 25 percent, or in a range of 23-28 percent), with the highest investment rates typically belonging to those nations that have shown the most rapid economic growth (Asian Tigers or NICs).
The real interest rate was defined earlier as the nominal interest rate on loans minus the rate of inflation. The real interest rate is equal to the return on capital. As Parkin notes, there are many real interest rates in the world economy, but they tend to move together (cf., term structure of interest rates, expectations of inflation and risk; note the difference between ex ante and ex post). This is because of the international mo-bility of capital: if real interest rates are especially high in one country, that will attract capital and hence push rates down.
The real interest rate (at which large corporations can borrow) is presently about 6 percent in the U.S., but has varied from levels of 2 percent and below in the 1970s (and even negative in 1975) to in excess of 8 percent in the mid-1980s.
Investment decisions
Business decisions concerning investment are influenced primarily by two factors: the expected profit rate from the investment, and the real interest rate. To estimate an expected profit rate, one must compare costs of an investment with expected returns. This task is complicated by the fact that costs typically are incurred primarily at the outset while returns accrue over an extended period of time (cf., building a factory that is expected to last for 40 years, assessing the desirability of building the Bryce Jordan Center).
One might initially try to add up costs and returns, but this fails to take into consideration the fact that, because of the presence of alternative investment opportunities (and independently of inflation), a dollar today is worth more than a dollar to be received in the future (cf., go to college and earn an extra half million dollars).
This aspect is taken into account by calculating the present
value of the net return, where present value is given by the
formula .(Note that Parkin avoids this issue by using simple examples
with one- year time horizons).
The value of i, the discount rate, that makes the net present value of an investment equal to zero is defined as the internal rate of return on the investment. We won't worry about calculating internal rates of return. The important thing to bear in mind is that the internal rate of return expected on an investment can be calculated, and it constitutes the expected profit rate on the investment (cf., investment in college).
This expected profit rate clearly will reflect the specific aspects of a particular investment. It is also likely to be influenced by the phase of the business cycle and by changes in technology. Typically, expected profit increases during business cycle expansions (when sales and utilization of capital tend to be higher) and decreases during contractions.
The real interest rate influences business investment decisions because it is in fact the opportunity cost of funds used to finance investment. This is true whether a firm borrows at the real interest rate or uses retained earnings to finance an investment (and hence forgoes receiving the real interest rate as a return from loaning out those funds elsewhere).
At the level of the individual investment project, then, an investment will be worth carrying out only if the expected profit rate (rate of return) exceeds the real interest rate (the cost of making the investment). Hence, it should be clear that in the aggregate, the higher is the level of the real interest rate the lower will be the level of investment. That is, projects that are worthwhile when the cost is low may not be worth it when the cost is high.
This last point brings us directly to the notion of investment demand: the relationship between the level of planned investment and the real interest rate, all other factors influencing the level of planned investment remaining equal. From the discussion above, it should be clear that there will be a downward-sloping investment demand curve (with quantity of investment on the horizontal axis and the real interest rate on the vertical axis) that will shift out when the expected profit rate increases (as in periods of business cycle expan-sion) and will shift to the left when the expected profit rate decreases (Fig. 8.4b).
As Parkin notes in his discussion of investment demand in the U.S., changes in the expected profit rate appear to be more important than changes in the real interest rate in contributing to changes in the amount of investment in the economy (i.e., shifts in the investment demand curve are more important than movements along the curve). This reflects the fact that investment demand curves are relatively steep.
Savings, consumption, and interest rates
If we have a demand curve for investment, then you can be sure that there must be a supply curve as well. As we noted earlier, investment is financed in large part from national saving (as well as from borrowing from the rest of the world). Consider the savings decision of households: after paying taxes, disposable income must be divided between consumption and saving. Hence, consumption and saving decisions are really a single decision about allocation of disposable income.
A key factor influencing this decision is the real interest rate. Higher real interest rates encourage greater saving, and since the saving/consumption decision is intertwined, higher real interest rates result in lower consumption. Note that the real interest rate is in fact the opportunity cost of consumption. We now have our upward-sloping supply curve of saving, then: aggregating over all households, we expect higher real interest rates to elicit higher levels of saving (there will also be a corresponding downward-sloping consumption demand curve; Fig. 8.6).
In addition to the real interest rate, the amount of saving in
the economy will also be influenced by the level of disposable
income. Greater disposable income typically entails increases in
both consumption and saving, the amounts being reflected by the
marginal propensity to consume (MPC, equal to 
) and the
marginal propensity to save (MPS, equal to 
). Hence,
changes in disposable income shift out the saving supply curve in
the same direction (Fig. 8.7b).
Parkin discusses two further influences on the supply of saving: the purchasing power of net assets and expected future income. Increases in each of these factors contributes to increased consumption and hence (holding disposable income constant) reduced saving.
Equilibrium in the global economy
The investment demand curve and the supply of saving curve meet to determine an equilibrium real interest rate. In contrast to all other markets that we analyze, the market for saving and investment is best considered from a global point of view, because of the easy international mobility of capital. (Note role of risk as an influence on international differences in real interest rates.) Global saving and global investment demand determine the real interest rate on a worldwide basis.
By aggregating investment demand curves across countries, we get a global investment demand curve. Similarly, we can envision a world saving supply curve, and the intersection of these two curves determines the equilibrium real interest rate. As can be seen in Parkin's Fig. 8.10, a real interest rate above the equilibrium level will result in a surplus of saving, and as with all surpluses there will be downward pressure on price (the real interest rate). As the real interest rate declines the quantity of investment demanded rises and the quantity of saving supplied falls until the two are brought into equilibrium. Similarly, a real interest rate below the equilibrium level will yield a shortage of saving for investment, and the resulting upward pressure on price will bring saving back into equilibrium with investment.
© 1996 David Shapiro
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