Investment and

Investment Function

Investment

� Net addition to the existing stock of capital assets

E.g. new machines, factories and plants

� Does not refer to the purchase of existing bonds, securities, debentures, etc.

� Only real investment creates additional employment

Effective Demand

ED = C + I

� Consumption function is more or less stable in the short-run

� Investment is the strategic variable for increasing employment

Characteristics of investment

� Most volatile component of GDP from demand / expenditure side

� Pro-cyclical

� Largely responsible for business cycles

� Major determinant of economic growth

� Dual role � Aggregate demand

� Aggregate supply

� Self terminating and self financing

Components of investment

Classified into three categories:

� Fixed non-residential investment

� Inventory investment

� Fixed residential investments

Motivation for

Investment

Business fixed investment

� Production requires factories & equipment –firms must invest in order to produce

� Increased production requires increased investment in fixed assets unless they have idle capacity

� Firms tend to invest more when labour cost relative to capital rental goes up

� To emphasize innovations

� Rental firms invest as they are in the business of renting out these assets to production firms

Investment in inventories

� Production Smoothing

� Factor of production

� Stock-out avoidance

� Work-in-progress

Fixed Residential Investment

� It is undertaken by households to own and live in their own houses

� Landlords invest as they are in the house-renting business.

Investment and Capital

� While investment is a flow, capital is a stock

� Capital is cumulative net investment:

t

Kt = Σ Ii

i=1

where Kt = capital at time t

Ii = net investment made during time period i.

� Net investment

= gross investment – depreciation

� Capital is measured at a point of time

Point to note:

� If it is measured at the beginning of the period, it does not include investment made in that period

� If it is measured at the end of the period, it is inclusive of current investment

Kinds of Investment

Public investment

� Investment is autonomous

� Quite arbitrary, i.e. without reference to market conditions (MEC or rate of interest)

Private investment

� Investment made by the private investors – households or firms

� Investment depends on market conditions� High during prosperity

� Low during recession / depression

Determinants of

Investment

Private Investment

Volume of investment

Depends upon two factors:

� Marginal efficiency of capital (MEC)

� Rate of interest

� Rate of interest does not change much –sticky or constant

� MEC determines the volume of investment in a community

� Fluctuations in investment are mainly due to fluctuations in MEC

MEC

� The expected profitability of a capital asset

Definition:

� Highest rate of return over cost expected from

the marginal or additional unit of the capital

asset

� Refers to

� Marginal unit

� Cost has to be deducted from returns

Two factors determine MEC

� Prospective yield from capital asset

� Supply price of capital asset

Prospective Yield of Capital

� Total net returns expected from the asset over its lifetime.

‘net’ means gross proceeds minus the ‘running costs’ of the asset

� Add together the annual net returns expected from the asset during its lifetime.

Points to note……

� reference here is not to the actual but to the expected annual returns from the asset.

� the asset is not to be considered in the sense of existing asset but in the sense of a brand new asset.

� all prospective net annual returns from an asset (during its lifetime) may not be equal, unless we assume the existence of a stationary or static society.

Supply price

� Supply price is the cost of producing a brand new asset of that kind, not the supply price of an existing asset.

� The supply price of an asset is also referred to as its replacement cost.

Determining MEC

Relating the two factors – prospective yield and supply price – gives MEC of an asset.

The MEC of an asset thus, means what an investor expects to earn from an additional unit of it compared with what it costs him.

Supply price = discounted prospective yield

R1 R2 Rn

Cr = -------- + --------- + ------+ ---------

(1+r) (1+r)2 (1+r)n

Where Cr = supply price of new capital asset

R1, R2 ---- = expected annual returns

r = rate of discount which makes present value of the series of annual returns equal to the supply price

Rate of Interest

� Price paid for loanable funds

� Determined by supply and demand for loanable funds

MEC & Rate of Interest

Potential investor will weigh MEC on new investment with rate of interest

� MEC > rate of interest

Investment will be made

� MEC = rate of interest

Equilibrium investment

Supply

Price

Annual

Return

MEC Rate of

Interest

Effect on

Investment

Rs.

25,000

Rs.

1,000

4 % 4 % Neutral

Rs.

25,000

Rs.

1,000

5 % 4 % Favourable

Rs.

25,000

Rs.

1,000

4% 5 % Adverse

At a Glance

Volume of Investment

MEC Rate of Interest

Supply Price Prospective Yield of Capital Demand for Funds Supply of Funds

Sale of output

Running costs

Factors Affecting

MEC

Short-run Factors

� Expected demand

� Costs and prices

� Propensity to consume

� Current state of expectation

Long-run Factors

� Rate of growth of population

� Development of new areas / markets

� Technological progress

� Productive capacity of existing capital equipment

� Rate of current investment

Investment Function

� Investment expenditure depends positively on the scale / financing / source variable and its yield, e.g. output is the scale variable, profitability the yield.

� Varies negatively with its cost, e.g. interest and depreciation rates.

I = f (Y, r, Q, FMP, F, T, BC, Y-1, K-1, µµµµ)

Where I = net investment� Y = output / income

� r = rate of interest� Q = Tobin’s Q

� FMP = fiscal and monetary policy

� F = financial constraints� T = technology

� BC = business confidence� Y-1 = output in previous year

� K-1 = stock of capital in previous year

� µ = other factors

� Output / income: investment is derived demand - will vary positively with changes in income

� Interest rate: investment has negative relationship with interest rate

Tobin’s Q

� Nobel prize winning economist James Tobin

Market value of installed capital

� Q = ------------------------------------------------

Replacement cost of installed capital

Q > 1: invest in more capital

Q < 1: investment will fall

Tax laws

� Corporate tax: levied on business profits (net of depreciation cost)

� Income tax: rules permit exemption on housing loans but not on rental income

� Other fiscal policies: capital subsidy, tax concessions/holidays

� Financing constraints

� Technology

� Business confidence