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14.4 Review and Practice


Investment is an addition to the capital stock. Investment may occur as a net addition to capital or as a replacement of depreciated capital. The bulk of investment spending in the United States falls into the latter category. Investment is a highly volatile component of GDP.

The decision to save is linked directly to the decision to invest. If a nation is to devote a larger share of its production to investment, then it must devote a smaller share to consumption, all other things unchanged. And that requires people to save more.

Investment is affected by the interest rate; the negative relationship between investment and the interest rate is illustrated by the investment demand curve. The position of this curve is affected by expectations, the level of economic activity, the stock of capital, the price of capital, the prices of other factors, technology, and public policy.

Because investment is a component of aggregate demand, a change in investment shifts the aggregate demand curve to the right or left. The amount of the shift will equal the initial change in investment times the multiplier.

In addition to its impact on aggregate demand, investment can also affect economic growth. Investment shifts the production possibilities curve outward, shifts the economy’s aggregate production function upward, and shifts the long-run aggregate supply curve to the right.

Concept Problems

  1. Which of the following would be counted as gross private domestic investment?

    1. General Motors issues 1 million shares of stock.
    2. Consolidated Construction purchases 1,000 acres of land for a regional shopping center it plans to build in a few years.
    3. A K-Mart store adds 1,000 T-shirts to its inventory.
    4. Crew buys computers for its office staff.
    5. Your family buys a house.
  2. If saving dropped sharply in the economy, what would likely happen to investment? Why?
  3. Suppose local governments throughout the United States increase their tax on business inventories. What would you expect to happen to U.S. investment? Why?
  4. Suppose the government announces it will pay for half of any new investment undertaken by firms. How will this affect the investment demand curve?
  5. White House officials often exude more confidence than they actually feel about future prospects for the economy. Why might this be a good strategy? Are there any dangers inherent in it?
  6. Suppose everyone expects investment to rise sharply in three months. How would this expectation be likely to affect bond prices?
  7. Suppose that every increase of $1 in real GDP automatically stimulates $0.20 in additional investment spending. How would this affect the multiplier?
  8. If environmental resources were counted as part of the capital stock, how would a major forest fire affect net investment?
  9. In the Case in Point on reducing private capital in the Great Depression, we saw that net investment was negative during that period. Could gross investment ever be negative? Explain.
  10. The Case in Point on lowering the tax rate for one year for companies that repatriated profits suggests that investment did not increase, even though company representatives are quoted as saying that they were using the repatriated profits for investment. Explain this seeming contradiction.
  11. Use the model of aggregate demand and aggregate supply to evaluate the argument that an increase in investment would raise the standard of living.

Numerical Problems

  1. Suppose a construction company is trying to decide whether to buy a new nail gun. The table below shows the hypothetical costs for the nail gun and the amount the gun will save the company each year. Assume the gun will last forever. In each case, determine the highest interest rate the company should pay for a loan that makes purchase of the nail gun possible.

      Cost Savings
    a. $1,000 $100
    b. $1,000 $200
    c. $1,000 $300
  2. A car company currently has capital stock of $100 million and desires a capital stock of $110 million.

    1. If it experiences no depreciation, how much will it need to invest to get to its desired level of capital stock?
    2. If its annual depreciation is 5%, how much will it need to invest to get to its desired level?
    3. If its annual depreciation is 10%, how much will it need to invest to get to its desired level?
  3. Burger World is contemplating installing an automated ordering system. The ordering system will allow Burger World to permanently replace five employees for an annual (and permanent) cost savings of $100,000.

    1. If the automated system cost $1,000,000, what is the rate of return on the investment?
    2. If the system cost $2,000,000, what would be its rate of return?
    3. If the government were to introduce an investment tax credit that allows firms to deduct 10% of its investment from its tax liability, what would happen to the rate of return if the system costs $1,000,000?
    4. If Burger World has to pay 8% to borrow the funds to purchase the system, what is the most it should pay for the system? Assume that there is no investment tax credit.
  4. The table below shows a number of investment projects and their effective earned interest rates or returns. Given the market interest rates shown below, identify which projects will be undertaken and the total amount of investment spending that will ensue.

    Project Return on project Cost
    A 30% $1,000  
    B 28         500  
    C 22      2,500  
    D 17      1,000  
    E   8          750   
    F   4       1,200  
    1. 20%
    2. 15%
    3. 10%
    4. 5%
    5. 3%
    6. Sketch out the investment demand curve implied by these data.
  5. The table below describes the amounts of investment for different interest rates.

    Interest rate Amount of investment (billions)
    25%   $5
    20    $10
    15    $15
    10    $20
      5    $25
    1. Draw the investment demand curve for this economy.
    2. Show the effect you would expect a decrease in the cost of capital goods to have on this investment demand curve.
    3. Show the effect you would expect an investment tax credit to have on this investment demand curve.
    4. Show the effect you would expect a recession to have on this investment demand curve.
  6. Suppose real GDP in an economy equals its potential output of $2,000 billion, the multiplier is 2.5, investment is raised by $200 billion, and the increased investment does not affect the economy’s potential.

    1. Show the short- and long-run effects of the change upon real GDP and the price level, using the graphical framework for the model of aggregate demand and aggregate supply.
    2. Would real GDP rise by the multiplier times the change in investment in the short run? In the long run? Explain.
  7. Use the information below to compute the levels of gross and net private domestic investment. Data are in billions of dollars.

    Change in business inventories $ 59.3

    Residential construction 369.6

    Producers’ durable equipment 691.3

    Nonresidential structures 246.9

    Depreciation 713.9

  8. Complete the table, which shows investment in the United States in billions of 2000 chained dollars.

      Year Gross private domestic investment Depreciation Net private domestic investment
    a. 2005 1,873.5 1,266.6  
    b. 2006   1,216.1 696.4
    c. 2007 1,809.7   546.7