CH14 - 14 INVESTMENTSPENDING FOCUSOFTHECHAPTER Investment...

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14 I NVESTMENT  S PENDING FOCUS OF THE CHAPTER • Investment  is the most volatile sector of aggregate  demand;  changes  in investment  account  for   much  of the change in GDP.   • The three types of investment  are  business fixed investment residential investment , and   inventory   investment . • Investment  is the flow of spending  that adds  to the physical stock of capital. • Investment  demand  is the primary  link between  monetary  policy and  aggregate demand.   Increased  interest rates reduce investment  because capital becomes more expensive. SECTION SUMMARIES 1. The Stock Demand for Capital and The Flow of Investment Businesses use machinery, equipment,  and  structures  to produce  output.   Together, these make   up  the stock of  business fixed capital .  This section develops  a theory  of the  desired capital   stock the capital stock firms would  like to have in the long run.   Because it takes time to order   and  install new  capital, firms do not always  have this desired  capital stock; investment the  flow of new  machinery  into the capital stock closes the gap  between  the desired  capital stock   and  the actual capital stock. Manufacturers  consider  three factors when  they decide how  much  capital they want  to have: the   amount  of output  they expect to sell, the amount  that one more unit of capital will increase their   output  (the  marginal product of capital ), and  the amount  that it will cost them  to use that unit of  capital (the  rental , or  user cost  of capital ). More capital always  enables us to produce  more output.   Each additional unit of capital costs the   same amount  to use, but each additional unit also contributes  less and  less to production.  This   153
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154 C HAPTER  14 combination  of constant  marginal cost and  diminishing  marginal  product  means  that there will   be some point  at which  it is no longer sensible for firms to buy  capital; eventually, the marginal   benefit that they derive from their capital will fall below  the marginal cost of employing  it.  Firms will therefore accumulate  capital as long as the marginal  benefit of their doing  so exceeds   the marginal cost.  The capital stock will be at its optimal or desired  level when  the marginal   benefit of employing  an additional unit of capital (i.e., the marginal product  of capital) is exactly   equal to the marginal  cost. The rental cost of capital is little more than  the expected  real interest rate (
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CH14 - 14 INVESTMENTSPENDING FOCUSOFTHECHAPTER Investment...

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