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INVESTMENT (Continued…):Inventories and the Real Interest Rate

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Macroeconomics ECO 403
VU
LESSON 43
INVESTMENT (Continued...)
Inventory Investment
·  Inventory investment, the goods that businesses put aside in storage, is at the same
time negligible and of great significance.
·  It is one of the smallest components of spending, yet its volatility makes it critical in the
study of economic fluctuations.
·  In recession, firms stop replenishing their inventory as goods are sold, and inventory
investment becomes negative.
1. When sales are high, the firm produces less that it sells and it takes the goods out
of inventory. This is called production smoothing.
2. Holding inventory may allow firms to operate more efficiently. Thus, we can view
inventories as a factor of production.
3. Also, firms don't want to run out of goods when sales are unexpectedly high. This is
called stock-out avoidance.
4. Lastly, if a product is only partially completed, the components are still counted in
inventory, and are called, work in process.
Seasonal Fluctuation and Production Smoothing
·  Contrary to the expectations of many economists and researchers, firms do not use
inventories to smooth production over time.
·  The clearest evidence comes from industries with seasonal fluctuations in demand. e.g. fan
manufacturing. One would expect that firms would build up inventories in times f low sales
and draw them down in times of high sales.
·  Yet in most industries firm do not use inventories to smooth production over the year, rather
seasonal pattern matches seasonal pattern in sales.
The Accelerator Model of Inventories
The accelerator model assumes that firms hold a stock of inventories that is proportional to
the firm's level of output.
When output is high, manufacturing firms need more materials and supplies on hand, and
more goods in process of completion.
When Economy is booming, retail firms want to have more merchandise on their shelves to
show customers.
·  Thus, if N is the economy's stock of inventories and Y is output, then
N=βY
where  is a parameter reflecting how much inventory firms wish to hold as a
proportion of output.
·  Inventory investment I is the change in the stock of inventories βN.
·  Therefore,
I = ΔN = β ΔY
The accelerator model predicts that inventory investment is proportional to the change in
output
When output rises, firms want to hold a larger stock of inventory, so inventory
·
investment is high
When output falls, firms want to hold a smaller stock of inventory, so they allow their
·
inventory to run down, and inventory investment is negative.
The model says that inventory investment depends on whether the economy is speeding up or
slowing down.
198
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Macroeconomics ECO 403
VU
Inventories and the Real Interest Rate
·  Like other components of investment, inventory investment depends on the real
interest rate.
·  When a firm holds a good in inventory and sells it tomorrow rather than selling it today,
it gives up the interest it could have earned between today and tomorrow.
·  Thus, the real interest rate measures the opportunity cost of holding inventories.
·  When the interest rate rises, holding inventories becomes more costly, so rational firms
try to reduce their stock.
·  Therefore, an increase in the real interest rate depresses inventory investment.
199
Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand