“Aggregate

investment is independent of economic growth.” Explain and critically appraise

the economic theory underpinning this statement.

Investment is the net change in capital stock:

. In order to

explain the determinants of aggregate investment, a microfounded model is used

to determine what affects a firms’ investment decisions. The revenue of a firm generated by its capital stock given by ,

where ,

with price, ,

and output, .

Assuming the real interest rate, ,

remains constant, the discounted net present value of the revenue stream is

given by .

A higher interest rate decreases as the cost of borrowing is increased and it

will cost more for a firm to increase its capital stock, thus reducing investment;

this gives the inverse relationship between investment and the real interest

rate. A firms’ objective is to maximise the

profits, so investment is chosen by the firm to maximise the net present value

of the profit stream generated by capital, ,

where is the cost of investment. This maximisation

gives an optimal level of capital stock, ,

and a firm makes an investment to increase capital to this level. The following

models, Tobin’s Q model and the Accelerator model, act under different conditions

regarding competition, perfect or imperfect, and the presence of adjustment costs.

In Perfect competition, prices are exogenous, so investment has no effect on

the price. In imperfect competition, prices are endogenous and determined by

demand. Adjustment costs are the costs a firm incurs as a result of increasing the

capital stock. For example, if the

capital stock is increased through the acquisition of new equipment, staff training

may be required in order to use it; this in an extra cost outside the purchase

of capital goods.

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The first model operates under the assumes

perfect competition and the presence of adjustment costs. Under perfect competition,

the scale of the firm is optimised so an increase in demand would increase the

price of a firms output. There are an infinite number of firms in the market,

so the investment is shown in the entry of new firms. As a result, at the

microfounded level, economic growth is independent of investment. Adjustment costs

are assumed to be convex; as capital stock increases, adjustment costs increase

sat a higher than proportional rate. In this model, the adjustment cost

function is quadratic, and the investment cost function is given by . Furthermore, assume that the production

function is linear, . Firms will

choose investment to maximise , where is the rate at which capital,, depreciates

each period . This maximisation gives , which can be

written as , where q, or

marginal q, is given by ; this is Tobin’s

Q model. Marginal q is the ratio of marginal product of capital to the marginal

cost of capital, the interest and depreciation lost from investing in capital instead

of a financial asset; when profit is maximised, marginal revenue is equal to

marginal costs, and q is equal to 1. If q > 1, the capital stock needs to be increased

to the optimal level. The amount of investment required depends on the marginal

cost of adjusting capital stock, . Given an

increase in the value of , the level of investment

decreases and the time taken for a firm to reach its optimal level,,

increases. An increase in the relative

price of capital goods, , reduces the level

of investment, , for a given amount

of capital stock, . Likewise,

increasing the real interest rate, , results in a

higher opportunity cost from investing in capital. In this model, prices and depreciation

are held constant and only is endogenous. Therefore,

the inverse relationship of investment and real interest rate holds, meaning

that Tobin’s Q is a sufficient determinant of investment.

As q is a marginal value, it is difficult to measure, as marginal

values are not easily observable.

In this model, imperfect competition is assumed, so prices are

endogenous. For a monopolist firm, the representative firm in this model, the

demand function, which is downward-sloping, is . This gives the

price function, , where is aggregate demand, is the number of sectors and is the firms’ output; in a monopoly each firm

is a sector; is the elasticity of demand. Each sector is

assumed to be the same size, is the average economic outp”Aggregate

investment is independent of economic growth.” Explain and critically appraise

the economic theory underpinning this statement.

Investment is the net change in capital stock:

. In order to

explain the determinants of aggregate investment, a microfounded model is used

to determine what affects a firms’ investment decisions. The revenue of a firm generated by its capital stock given by ,

where ,

with price, ,

and output, .

Assuming the real interest rate, ,

remains constant, the discounted net present value of the revenue stream is

given by .

A higher interest rate decreases as the cost of borrowing is increased and it

will cost more for a firm to increase its capital stock, thus reducing investment;

this gives the inverse relationship between investment and the real interest

rate. A firms’ objective is to maximise the

profits, so investment is chosen by the firm to maximise the net present value

of the profit stream generated by capital, ,

where is the cost of investment. This maximisation

gives an optimal level of capital stock, ,

and a firm makes an investment to increase capital to this level. The following

models, Tobin’s Q model and the Accelerator model, act under different conditions

regarding competition, perfect or imperfect, and the presence of adjustment costs.

In Perfect competition, prices are exogenous, so investment has no effect on

the price. In imperfect competition, prices are endogenous and determined by

demand. Adjustment costs are the costs a firm incurs as a result of increasing the

capital stock. For example, if the

capital stock is increased through the acquisition of new equipment, staff training

may be required in order to use it; this in an extra cost outside the purchase

of capital goods.

The first model operates under the assumes

perfect competition and the presence of adjustment costs. Under perfect competition,

the scale of the firm is optimised so an increase in demand would increase the

price of a firms output. There are an infinite number of firms in the market,

so the investment is shown in the entry of new firms. As a result, at the

microfounded level, economic growth is independent of investment. Adjustment costs

are assumed to be convex; as capital stock increases, adjustment costs increase

sat a higher than proportional rate. In this model, the adjustment cost

function is quadratic, and the investment cost function is given by . Furthermore, assume that the production

function is linear, . Firms will

choose investment to maximise , where is the rate at which capital,, depreciates

each period . This maximisation gives , which can be

written as , where q, or

marginal q, is given by ; this is Tobin’s

Q model. Marginal q is the ratio of marginal product of capital to the marginal

cost of capital, the interest and depreciation lost from investing in capital instead

of a financial asset; when profit is maximised, marginal revenue is equal to

marginal costs, and q is equal to 1. If q > 1, the capital stock needs to be increased

to the optimal level. The amount of investment required depends on the marginal

cost of adjusting capital stock, . Given an

increase in the value of , the level of investment

decreases and the time taken for a firm to reach its optimal level,,

increases. An increase in the relative

price of capital goods, , reduces the level

of investment, , for a given amount

of capital stock, . Likewise,

increasing the real interest rate, , results in a

higher opportunity cost from investing in capital. In this model, prices and depreciation

are held constant and only is endogenous. Therefore,

the inverse relationship of investment and real interest rate holds, meaning

that Tobin’s Q is a sufficient determinant of investment.

As q is a marginal value, it is difficult to measure, as marginal

values are not easily observable.

In this model, imperfect competition is assumed, so prices are

endogenous. For a monopolist firm, the representative firm in this model, the

demand function, which is downward-sloping, is . This gives the

price function, , where is aggregate demand, is the number of sectors and is the firms’ output; in a monopoly each firm

is a sector; is the elasticity of demand. Each sector is

assumed to be the same size, is the average economic output for each firm,

and and are fixed parameters. For a given level of

demand, increasing in capital stock and therefore the scale of the firm, would

result in a decline in the prices of output. As a result, investment will be

chosen by maximising , where, to

simplify the model, there are no adjustment costs and ; therefore, the marginal,

and average, product of capital is constant. The maximisation gives . Given a small

value for , is equal to economic growth; given the

interest rate, , is constant, this

is the accelerator model for investment. As investment is determined by an

increase in aggregate demand, it is not independent of economic growth in this

model.

ut for each firm,

and and are fixed parameters. For a given level of

demand, increasing in capital stock and therefore the scale of the firm, would

result in a decline in the prices of output. As a result, investment will be

chosen by maximising , where, to

simplify the model, there are no adjustment costs and ; therefore, the marginal,

and average, product of capital is constant. The maximisation gives . Given a small

value for , is equal to economic growth; given the

interest rate, , is constant, this

is the accelerator model for investment. As investment is determined by an

increase in aggregate demand, it is not independent of economic growth in this

model.