Until now, we have been treating the amount of business investment as exogenous. However, investment responds to other macroeconomic variables, including the interest rate, which up until now has not appeared in our macroeconomic model.

The simplest way to introduce investment is to treat the interest rate as exogenous. Let us suppose that the interest rate is 2.0 percent. If the interest rate were higher, then the cost of capital would be higher. If the cost of capital is higher, then firms will substitute away from capital, which means investing less. Thus, investment is negatively related to the interest rate. For example, if we let r stand for the interest rate, we could have

[4'] I = $2.8 - $0.5r = $2.8 - $0.5(2.0) = $1.8 trillion

More generally, if we let I0 be the intercept and h be the slope of the investment equation, then we have

[4] I = I0 - hr

This is equation [4], because we could combine it with our previous three equations.

[1] Y = C + I + G
[2] C = C0 + c(Y-T)
[3] T = T0 + tY

Now, we have four equations. What are the four endogenous variables? What are the exogenous variables? What are the coefficients?

Substitute equations [2], [3], and [4] back into equation [1], and solve for Y as a function of the coefficients and the exogenous variables.

We can combine the numerical values of equations [1'] - [4']. That is, we have

[1'] Y = C + I + G = C + I + $1.7 = $10.2 trillion
[2'] C = $1.54 + (0.6)(Y-T) = $1.54 + (0.6)($10.2 - $1.6) = $6.7 trillion
[3'] T = -$0.44 + 0.2Y = -$0.44 + 0.2($10.2) = $1.6 trillion
[4'] I = $2.8 - 0.5r = $2.8 - 0.5(2.0) = $1.8 trillion

Monetary and Fiscal Policy

The government can influence the interest rate through its use of monetary policy. In the United States, monetary policy is conducted by the Federal Reserve Board, under its current Chairman, Alan Greenspan.

Suppose that the interest rate falls from 2.0 percent to 1.8 percent. What happens to the level of investment? What happens to the level of income? Solve for the new values in the numerical example.

We now have identified the two main policy levers that the Federal government has available for raising the level of output. Fiscal policy is the government's use of tax cuts or increases in government spending to boost the economy (or the use of tax increases and spending cuts to cool the economy). Monetary policy is the use of lower interest rates to stimulate the economy (or higher interest rates to cool the economy).

The Determinants of Investment

In classical economics, the desire to invest and the desire to save both stem from the same source: a willingness to forego consumption now in order to have more in the future. Saving is the means of setting aside output, and investment is the means of transforming output that is set aside today into capital that will produce output in the future. Classical economists saw desired saving and investment as naturally balanced.

Keynes saw saving and investment as two different psychological mechanisms. He saw saving as the desire to hoard or accumulate wealth, which is motivated by fear or pessimism. He saw investment as the desire to create, which is motivated by optimism or what Keynes called the "animal spirits" of the entrepreneur. Keynes thought that much of the time the "animal spirits" would be too weak, and the strength of the hoarding motive would create an excess of desired saving over investment.

The Keynesian analysis can be applied to the Internet Bubble or "dotcom mania" and its aftermath. In Keynesian terms, optimism about the prospects for Internet companies, particularly in 1999 and early 2000, meant that "animal spirits" were strong and investment was high. This raised the level of output and caused a powerful economic expansion. Once the bubble popped, the hoarding instinct took over, and the economy slumped.

Nobel laureate James Tobin elaborated on Keynes' theory of investment. He introduced a concept, now called Tobin's q, which is the ratio of the market value of capital to its replacement cost. The market value of capital is the value of stock prices. The replacement cost of capital is the cost of buying all of the plant and equipment needed to build the companies that are traded on the stock market.

The natural value for q is 1.0, which means that stocks are neither under-valued nor overvalued. When q is higher than 1.0, there is strong motivation to undertake capital investment. When q is below 1.0, there is little motivation to undertake capital investment.

For example, during the dotcom mania, companies with few assets other than some computers and software programs to run on the Web were valued at billions of dollars. Thus, the ratio of their market value to their replacement cost was enormous. This led to many Internet companies being started by entrepreneurs and funded by venture capitalists. However, once the bubble burst and the value of q fell from its stratospheric levels, investment in dotcoms ground to a halt.

The theories of Keynes and Tobin are rather at odds with the theory of efficient markets that we looked at in finance. If Keynes and Tobin are correct, then the stock market is subject to strong psychological mood swings that cause prices to far away from fundamental values. It is still impossible to make a profit from short-term trading, but if Keynes and Tobin are correct then buying stocks when price-earnings ratios are unusually low and selling when P/E ratios are unusually high will be a winning long-term strategy.