Investment Function

Chapter 6: Investment Function

Learning Objectives:
To define the Basic Concept of Investment To define Investment Function and its Multiplier Why investment is negatively related to the interest rate. What causes the investment function to shift. Discuss the Acceleration Principle
Chapter 6: Investment Function

Learning Objectives
To define the Roles of Savings in Investment To discuss Investment Determinants To discuss Investment Demand-Supply and Foreign Borrowings To discuss the Business Cycle In Investment

Chapter 6: Investment Function

Investment: A Determinant of Income

Chapter 6: Investment Function

Investment
Putting money into something with a hope of short-term gain, with or without thorough analysis, as gambling or speculation. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth.

Chapter 6: Investment Function

Investment spending is an injection into the circular flow of income. Firms invest for two primary reasons: 1. Firstly, investment may be required to replace worn out, or failing machinery, equipment, or buildings. This is referred to as capital consumption, and arises from the continuous depreciation of fixed capital assets. 2. Secondly, investment may be undertaken to purchase new machinery, equipment, or buildings in order to increase productive capacity. This will reduce long-term costs, increase competitiveness, and raise profits.
Chapter 6: Investment Function

 Gross investment includes both types of investment spending, but net investment only measures new assets rather than replacement assets. This relationship is expressed in the following equation:
Net investment = GI depn
In economic theory, net investment carries more significance, as it provides the basis for economic growth.
Chapter 6: Investment Function

Significance of Investments
1. It contributes to current demand of capital goods, thus it increases domestic expenditure; 2. It enlarges the production base (installed capital), increasing production capacity; 3. It modernizes production processes, improving cost effectiveness; 4. It reduces the labor needs per unit of output, thus potentially producing higher productivity and lower employment;
Chapter 6: Investment Function

5. It allows for the production of new and improved products, increasing value added in production; 6. It incorporates international worldclass innovations and quality standards, bringing the gap with more advanced countries and helping exports and an active participation to international trade.
Chapter 6: Investment Function

Investment and Output

Chapter 6: Investment Function

 There are two factors that cause the capital stock to change
Investment of new machinery and structure Depreciation

Chapter 6: Investment Function

 Gross investment is the amount of the new capital being added to an economy Net Investment = Gross Investment less Depreciation

Chapter 6: Investment Function

K(t) = K(t + 1) + I(t) D(t) K(t) = capital stock I(t) = gross investment D(t) = depreciation I(t) D(t) = Net Investment

Chapter 6: Investment Function

Chapter 6: Investment Function

What is Savings?
A part of income which is not consume or not spent.

Chapter 6: Investment Function

Major purchases
Emergencies
Saves money for a rainy day

Retirement

Chapter 6: Investment Function

 The Role of Savings

Keynesian theory:

Savings are a leakage from our economy. Only increases in consumption lead to increases in production.

Chapter 6: Investment Function

Additional Information:
The Keynesian Model:

is based on the works of John Maynard Keynes (1883 1946). gained acceptance during the 1930s and was supported by almost all western economists and politicians during the 1950s, 1960s, and 1970s.

Macroeconomics

Keynes said: In the long run we are all dead. Do you agree?
1. 2. 3. 4. Yes No Not sure I dont care (were all dead soon)

0 of 5

:10

In Fact:

Keyness Analogy

The economy is like an elevator. If it goes up, it will continue to go up for a while. If it goes down, it will go down and may hit the bottom, unless someone stops it.

Macroeconomics

The Keynesian Solution

The government must intervene (stop the elevator) through: 1. Active fiscal policy 2. Active monetary policy

Macroeconomics

 The Role of Savings

Classical Theory: Savings are important to our economy. Increases in savings lead to increases in funds for businesses. Businesses use these funds for research and technology and business expansions.

The Role of Savings

Investments in research and technology lead to increases in productivity. This enables businesses to pay higher real wages. This leads to real (not artificial) increases in demand.
Chapter 6: Investment Function

The Role of Savings

Real demand increases are made possible by greater capacities to produce, and not by artificial increases in government spending or newly printed money.

Chapter 6: Investment Function

Savings-Investment Equilibrium Point

Savings and investment can also help the economy reach an equilibrium. An increase in savings leads to a decrease in national product whereas an increase in investment demand leads to an increase in national product. When savings equal investments, the economy reaches its equilibrium point.
Chapter 6: Investment Function

Determinants of C & S
Wealth
Increased wealth .: Inc. C & Dec. S Decreased wealth .: Dec. C & Inc. S

Expectations
Positive .: Inc C & Dec S Negative .: Dec C & Inc S

Household Debt
High Debt .: Dec C & Inc S Low Debt .: Inc C & Dec S

Taxes
Taxes Inc .: Dec C & Dec S Taxes Dec .: Inc C & Inc S

Accleration Principle
An economic concept that draws a connection between output and capital investment. If demand for consumer goods increases, then the percentage change in the demand for machines and other investment necessary to make these goods will increase even more (and vice versa).
Chapter 6: Investment Function

 In other words, if income increases, there will be a corresponding but magnified change in investment. The acceleration principle has the effect of exaggerating booms and recessions in the economy.

Chapter 6: Investment Function

 This makes sense, as companies want to optimize their profits when they have a successful product, investing in more factories and capital investments to produce more. If a recession hits, they will reduce investment.

Chapter 6: Investment Function

 This investment reduction can increase the length of the recession. This is because less investment means less jobs created, and so on.

Chapter 6: Investment Function

Chapter 6: Investment Function

Determinants of Investment
Expectations The expectations of business owners and management for future growth and sales of their products. Future sales, future economic factors, future trends. Interest Rates The current and expected rates of interest for loans. Businesses need to borrow to expand if rates are low this is favorable. At higher rates of interest business investment declines.

Chapter 6: Investment Function

Determinants of Investment
Technology and Innovation The impact of improved technology and innovation on the ability to manufacture goods at a lower cost. Improving technology can improve profits and increase investment in other improvements.

Chapter 6: Investment Function

Investment Function
Real interest rate

Real interest rate

I(r)
Investment

I1

I2

Investment

Investment is a negative Investment increases by function of real interest rate. technological advancement.
Chapter 6: Investment Function

Investment Demand And Interest Rates

Better expectations cause a shift rightward Movement up the existing curve is caused by an increase in interest rates

11 10 9 8 7 6 5 4 3 2 1 0

Interest Rate (percent per year)

I2

Initial expectations
11 Worse expectations The curve shifts left
100 200 300 400 500

I3

Planned Investment Spending (billions of dollars per year)

AGGREGATE DEMAND Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

AGGREGATE SUPPLY Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

 Investment increases the stock of capital available in the economy for production, and it is mainly affected by interest rates. Money supply affects interest rates. For example, if the money supply was to increase, this would lower interest rates and increase investment - therefore, shifting aggregate demand to the right. If there are higher expected returns on investment projects, this would increase the demand for capital goods and shift the aggregate demand curve to the right

 Interest rate The percentage of an amount of money charged for its use per some period of time (often a year). Investment increases the stock of capital available in the economy for production, and it is mainly affected by interest rates. Investment has a positive relationship with output and negative relationship with the interest rate. Investments are strongly affected by interest rates because they dictate the cost of borrowing money. For example, a rise in the interest rate will cause less private investments to be made, causing aggregate demand to decline. If interest rates were rather to decrease, lowering the cost of borrowing, investment would increase.

A decline in investment spending at each price level will shift the aggregate demand curve to the right. Factors affecting investment spending include the following: Real Interest Rates: An increase in interest rates would lower investment spending and reduce aggregate demand ("interest-rate effect"). Money supply affects interest rates. For example, if the money supply was to increase, this would lower interest rates and increase investment -- therefore, shifting aggregate demand to the right. However, if the reverse is true, this would increase interest rates and discourage investment, shifting the curve to the left. Expected Returns: If there are higher expected returns on investment projects, this would increase the demand for capital goods and shift the aggregate demand curve to the right.

 Expectations about future business conditions: If businesses speculate high rates of return on current investment, they will invest more. Technology: New technology would enhance expected returns on investment and increase aggregate demand.

 Degree of excess capacity: Too much excess of unused capital will reduce the expected return on new investment and decrease aggregate demand. Business taxes: An increase in taxes for businesses will reduce after-tax profits from capital investment and lower expected returns.

Chapter 6: Investment Function

Business Cycle
It refers to phenomenon of cyclical booms and depressions. According to Keynes A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages, altering with periods of bad trade characterised by falling prices and high unemployment percentages.

Phases of a Business cycle

Recovery or Expansion Phase: This phase starts after depression has lasted for some time and due to either exogenous or endogenous forces revival starts. This phase is characterised by steadily increase in level of employment, income and output. Prosperity: Demand, output, employment and income are at a high level. They tend to raise prices but wages and salaries do not rise to that extent as a result profit margin rises.larger profit expectations further rises investment. This peak may lead to over full employment in the economy and inflationary rise in prices. It is a symptom of the end of prosperity phase.

Phases
Recession: Downward descend from the peak which is of short duration. Its signs are liquidation in the stock market, strain in the banking system, liquidation of bank loans, and decline of prices. As a result of this profit margins decline further. Investment, employment, incomes and demand declines. Depression: General declines in economic activity.Considerable reduction in the production, employment, income, demand and prices.Bank rate falls considerably.

Hawtreys Monetary theory of Business cycle

According to him trade cycle is purely a monetary phenomenon as non monetary factors such as droughts and floods cause only a partial depression. Cyclical fluctuations are at the best caused by the contraction and expansion of credit by the banks which in turn leads to increase or decrease in the flow of monetary demand on the part of producers and traders. Recovery phase starts when the bank expand the credit facilities. Demand on the part of producers will ultimately lead to the conditions of boom. Boom period continue only for some time and it comes to an end when money with the bank is exhausted. From this point recession starts. People start repaying bank loans by selling their stocks and liquidating their assets. Thus money with the bank increases and that with the public reduces. This starts depression in the economy.

Schumpeters Theory of innovations

He believes that innovation is the source of economic fluctuations. Trade cycles are the outcome of economic development in a capitalist society. There are two stages in this model. The first stage deals with the initial impact of innovation and the second stage follows through reactions to the original impact of innovation. In the first stage every factor is fully employed and producing efficiently. There are no savings and investment. This equilibrium is called as circular flow by Schumpeter. This circular flow is broken by Innovation in the form of product, new method of production, new market, new source of material or new method of managing industry by an entrepreneur.

CAUSES OF INSTABILITY
Consumption: If households decide to buy more or less, the rest of the economy follows suit. Aggregate demand (see below) is the prime source of economic instability. Capital Investment: Big swings in investment levels can create upward or downward spirals of total production. Government Purchases and Taxes: Government purchases can have a contractionary or an expansionary effect over the economy. Taxes affect the ability of the household and business sectors to buy production.

 Net Exports: Changes in exports can trigger expansions and contractions of the domestic economy. Circulating Money: Too much money can trigger an inflationary expansion, too little money can trigger contraction and unemployment. Resource Supply Considerations: Resource supply changes (energy prices, technology, wages, etc.) can trigger expansions and contractions.

Surprise Growth: 6.2 %

Election spending and higher usage of cellular phones allowed the Philippine economy to grow 6.2 percent in April-June despite the governments fragile fiscal position. This lifted the growth of gross domestic product (GDP), the total value of goods produced and services rendered in the country, in the first six months to 6.3 percent in the same period last year.

In the know Why is the economy growing despite the fiscal crisis?