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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
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.
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
There are two factors that cause the capital stock to change
Investment of new machinery and structure Depreciation
Gross investment is the amount of the new capital being added to an economy Net Investment = Gross Investment less Depreciation
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
What is Savings?
A part of income which is not consume or not spent.
Major purchases
Emergencies
Saves money for a rainy day
Retirement
Keynesian theory:
Savings are a leakage from our economy. Only increases in consumption lead to increases in production.
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 government must intervene (stop the elevator) through: 1. Active fiscal policy 2. Active monetary policy
Macroeconomics
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.
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.
This investment reduction can increase the length of the recession. This is because less investment means less jobs created, and so on.
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.
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.
Investment Function
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
11 10 9 8 7 6 5 4 3 2 1 0
I2
Initial expectations
11 Worse expectations The curve shifts left
100 200 300 400 500
I3
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.
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
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.
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.
In the know Why is the economy growing despite the fiscal crisis?