Fixed Business Investment. In this problem, we will derive the function for fixed business investment and analyze its implications.
a.) To build the investment function, we consider two different types of firms: production firms and rental firms. How do the two firms differ?
b.) The cost of capital for a rental firm can be written in equation form as: Cost of Capital = iP + P. What do each of the three terms (iP, P, and P) represent, and how do each of them affect the cost of capital? In other words, how does a change in iP affect a rental firm's ability to invest in capital?
c.) Recall that the nominal interest rate is equal to the real interest rate plus inflation (i = r + π). Use substitution to simplify the equation such that the cost of capital is written in terms of its price, the real interest rate, and the depreciation rate.
d.) Firm investment is a function of the profit rate of investing capital, which is equal to real rental revenue minus the real cost of capital. What is the real rental rate of capital equal to? Use this and your answer to part c.) to write the profit rate equation.
e.) Total fixed business investment is equal to the sum of this function of the profit rate and what other factor? Why?