Investment

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UMAIR

Investment Defined Investment is any new plant, equipment, additional inventory, computer

software, or residential housing. Plant includes factories, office buildings, department and other retail stores,

and shopping malls. Examples of equipment are assembly lines, machine tools, display cases, cash registers, computer systems, and office furniture—as long as businesses purchase them.

For example, if you buy a car for your personal use, it’s a consumption expenditure. But if Shell Oil buys a car for its executives to ride around in (on company business), then it’s an investment.

The key question we must ask is whether the purchase adds to a company’s plant, equipment, or inventory. If not, then it’s not investment. What if your town buys a new police car or a new PC or puts up a new school? Is this investment?

When the government makes these purchases, it’s government spending rather than investment

Investment DefinedWhat if you were to purchase 100

shares of Intel stock? Would that be investment?

Does that add (directly) to Intel’s plant, equipment, or inventory? It doesn’t? Then it isn’t investment.

It’s merely a financial transaction. When Intel uses those funds to buy

plant, equipment, or inventory, then it’s investment.

Investment Defined Inventory includes goods on store shelves waiting to be

sold, cars in a showroom or car lot, finished goods in a factory waiting to be shipped, and even parts of a product ready to be assembled.

Business firms do not want to hold more inventory than they need because that inventory ties up money and also incurs storage costs.

Suppose you owned a toy store and had sales of $10,000 a week. Would you want to carry an inventory of $100,000 toys?

Today, with inventory computerization, many firms use the just-in-time method of inventory control.

Faster delivery systems —think of UPS and FedEx—also help companies to keep their inventories lower.

Stores and factories, many tied to the Internet, have found they can cut costs by shrinking the warehouses where they store the materials they use in production or the goods they sell later to consumers.

Investment DefinedCalculating inventory investment

is a little tricky. We include only the net change

from January 1 to December 31 of a given year.

For example, we can calculate how much was inventory investment for General Motors in 2003 using the figures in the followung Table.

Investment Defined

Date Level of Inventory

January 1, 2012 $ 120 million

July 1, 2012 145 million

December 31, 2012 130 million

Hypothetical Inventory Levels of General Motors

Investment DefinedHow much was GM’s inventory

investment in 2012? $25 million? Nope. $395 million?

Nope. The answer is $10 million. All you have to do is look at the levels of inventory on January 1 and December 31 and calculate the difference.

How does savings gets investedHow does savings get invested? A good

question. Well, for starters, what do you do with the money you save? Put it in the bank? Buy stocks? Buy corporate bonds?

Nearly all the money that flows into the stock market buys stock that has already been issued.

So you might buy 500 shares of Cisco, but someone else has sold those 500 shares.

However, initial public offerings (IPOs) and new issues of stock raise money, all of which goes directly to the corporations issuing stock.

And most of that money finances capital spending.

How does savings gets investedIf you deposit your money in a bank, much

of it will end up being invested by large business borrowers.

What the banks do is package a large number of deposits into a much smaller number of substantial business loans.

When IBM, Dell, General Motors, and Verizon come calling on their bankers, they’re going to borrow hundreds of millions or even billions of dollars—so much, in fact, that loan syndicates of dozens of banks are often formed to raise the total amount needed.

How does savings gets invested Let’s make a clear distinction between “financial”

investment and “real” investment. When you buy corporate stocks and bonds, a bank

certificate of deposit (CD), or any other financial security, you may consider that an investment.

But economists will tell you that while you made a personal financial investment, it was not a “real” investment.

The only investment that is real to economists is the purchase of a new home or the purchase by a business firm of new plant, equipment, or inventory.

Only “real” investment is counted in GDP. Suppose you bought 100 shares of Amazon.com, or you

invested $10,000 in a U.S. Treasury bond, or you bought part of Rockefeller Center. These were all investments, right? Wrong!

How does savings gets investedIn economics there are only two types of

investment: the purchase of (1) new plant, new equipment, and new

residential housing, and (2) additional inventory.What about all that money you “invested” in

stocks, bonds, and real estate? If those aren’t investments, what are they? They are financial transactions—mere exchanges of assets.

Now, there’s nothing wrong with these transactions, but they don’t go into GDP. And if they don’t, then they’re not investments.

Determinants of Level of InvestmentSales Outlook

◦ If you can’t sell your goods or services, there’s no point in investing, so the ultimate determinant of the level of investment is the business firm’s sales outlook.

◦ If business is good and sales are expected to be strong for the next few months, then business firms will be willing to take on more inventory.

◦And if sales look good for the next few years, additional plant and equipment will probably be purchased.

Determinants of Level of Investment

Capacity Utilization Rate

◦The capacity utilization rate is the percentage of plant and equipment that is actually being used at any given time.

◦Since it would be virtually impossible to use every single factory, office, and piece of machinery day in and day out, we will always have some idle plant and equipment.

Determinants of Level of Investment

◦For our purposes, we can count on the capacity utilization rate as an important influence on the level of investment in plant and equipment.

◦At high rates, companies have considerable incentive to build more plant and equipment because sales are pressing against factory capacity.

◦During really bad recessions, when demand is slack, one-third of our factories and equipment may be idle. Why build more?

Determinants of Level of InvestmentThe Interest Rate

◦The interest rate is the cost of borrowing money.

◦There are actually many different interest rates, depending on a firm’s creditworthiness and the size of the loan.

◦Suppose you want to borrow $1,000 for one year and the bank will charge you 12 percent interest.

◦How much interest will you have to pay if you borrow the $1,000 for one year?

Determinants of Level of Investment

Interest rate = Interest paid Amount borrowed

◦ In general, the lower the interest rate, the more business firms will borrow.

◦But to know how much they will borrow—or whether they will borrow at all in any particular instance—we need to compare the interest rate with the expected rate of profit on the investment.

Determinants of Level of InvestmentThe Expected Rate of Profit

Economists are not happy unless they give virtually the same concept at least three different names.

Therefore, the expected rate of profit is sometimes called the marginal efficiency of capital or the marginal efficiency of investment.

We’ll define it this way: Expected rate of profit = Expected profits Money

Invested

Determinants of Level of InvestmentNow, of course, we have to work

out a problem. Here’s an easy one: How much is

the expected profit rate on a $10,000 investment if you expect to make a profit of $1,650?

It will be 16.5%.

Determinants of Level of InvestmentKeynes said that every profit

opportunity would be exploited as long as the expected profit rate (which he called the “marginal efficiency of capital”) exceeded the interest rate:

“The rate of investment will be pushed to . . . where the marginal efficiency of capital in general is equal to the market rate of interest.”

Determinants of Level of InvestmentSuppose your business firm is interested in

borrowing $100,000 at the going interest rate of 15 percent to buy inventory.

If your expected profit rate is 18 percent, would it pay to borrow?

In other words, after you paid off the interest, how much money would you have left?

$18,000 - $15,000 in interest = $3,000. You would stand to make $3,000 profit. Of course you would borrow the money.

Autonomous Investment

It is the investment expenditure considered independent of the level of income.

It is called planned investment.

Autonomous Investment

While autonomous investment expenditures are unaffected by income and are held constant for the construction of the investment line, they are not absolutely constant, they do change.

Autonomous investment is affected by investment expenditures determinants, such as interest rates, expectations, technology, and capital prices.

Changes in these and other determinants cause changes in autonomous investment, which shift the investment line as well as the aggregate expenditures line and disrupt whatever equilibrium might exist.

Induced InvestmentIt is the part of the investment

which is influenced by the level of income.

When production and income change, some adjustment of expenditures needs to be made, and that adjustment is in the form of induced investment.

Autonomous and Induced Investment

Investment FunctionOne way to provide an illustration of autonomous

investment (and the relation to induced investment) is with a general linear investment equation, such as the one presented here: I = e + fY

where: I is investment expenditures, Y is income (or aggregate production), e is the intercept, and f is the slope.

The two key parameters that characterize this investment equation are slope and intercept.

Autonomous investment is indicated by the intercept of the investment equation.

Induced investment is then indicated by the slope.

Investment Function An Autonomous Intercept:The intercept of the investment equation

(e) measures the amount of investment undertaken if income is zero.

If income is zero, then investment is $e. The intercept is generally assumed and

empirically documented to be positive (0 < e).

It is conceptually identified as autonomous investment.

Investment Function An Induced Slope: The slope of the investment equation (f)

measures the change in investment resulting from a change in income.

If income changes by $1, then investment changes by $f.

This slope is generally assumed and empirically documented to be greater than zero, but less than one (0 < f < 1).

It is conceptually identified as induced investment and the marginal propensity to invest (MPI).