The Level of Investment

THE LEVEL OF INVESTMENT

CHAPTER 6

INVESTMENT is defined as the spending or purchase of plants, machineries, buildings and inventories by firms for the purpose of producing goods and services.

Investment (I)• A relationship between the rate of interest on

bonds and the level of investment spending by business firms

• A negative relationship—when interest rates fall, investment spending will increase

• If the rate of interest is given, the level of investment will be constant and not a function of income

Basic Concepts of Investment

Investment expenditure is capital spending mainly derived not from current income and consumption but from accumulated savings and other sources external to the circular flow. Current business income serves current business needs and the surplus may not suffice to finance even a fraction of investment spending as on new equipments.

INVESTMENT

andOUTPUT

[ Basic Concepts ]

Business and household investments tend to increase the economy’s stock of capital and total output; whereas depreciation has the opposite effect as it represents capital consumption. While current depreciation decreases total output in the short-run, current investment only yields output in the long-run for two reasons. First, even after total investment expenditure to meet production targets has already been incurred, the process of setting up and even testing the capital base creates operational lags. Second, every phase in setting up a capital base may not be capable of independent utilization until the completion of the other phases.

INVESTMENTand theSTOCK

ADJUSTMENT PROCESS

Despite the investment-production time lag, sustained investment patterns can determine trends in the capital stock and production level over a long period.

It should be understood at this point that capital stock is not a headcount but rather the aggregate production capacity of existing capital goods in the economy which can diminish due to usage and depreciation. However, investment increases the stock since additional capital brings additional production capacity.

The following framework illustrates investment-output relationship assuming a short-run time frame, no

investment-production lag and constant capital-output ratio:

Kf = ( Kj D + I )

Yf = ( Yi − ∆yd + ∆yi ) = a ( Ki − D ; I )

Where:

Kf = Stock of capital after Depreciation and Investment

Ki = Initial stock of capital i.e. before Depreciation and Investment

D = Depreciation

I = Investment

Yi = Initial output from the capital stock i.e. before Investment and Depreciation

Yf = Total output from the capital stock after Depreciation and Investment

∆yd = Change in total output because of Depreciation

∆yi = Change in total output because of Investment

a = output-capital ratio (Y/K)

Furthermore:Net change in capital stock

= ( − D + 1 )Net change in output

= ( − ∆ yd + ∆yi )

A positive (+) net change in the capital stock results in a positive (+) net change in output or an increase in both the capital stock and output. The opposite is true with a negative (-) net change in the capital stock. However, zero or no net change means a constant level in both the capital stock and output. Thus, investment adjusts the capital stock to maintain and even increase production and the level of economic activities. However, these effects can only be sustained in the long-run through continuous investment to offset the production-investment time lag.

SAVINGS as a

SOURCE of INVESTMEN

T

[ Savings concepts ]

Savings is the unspent portion of income during the period intended for spending as in case of a salary earner who sets aside a portion of his half month pay earmarked for the next fifteen days. It is residual of income which accumulates into a stock for future use and therefore, postpones current consumption.

However, savings yet to be spent in the long-run should be of particular interest to investment since it takes time for the latter to return the savings borrowed from the economy because of the long-term usage of capital.

On the other hand, it should be noted at this point that it is not the persons and businesses who save but the government as well to finance its investment on social overhead facilities.

However, it is the savings of the economy that affects the income multiplier since government savings generated outside circular flow.

Savings of the economy can be

simply expressed as

follows assuming that it is the only determinant of the multiplier.

S = Y − Cwhere:

S = SavingsY = Income

C = Consumption

The simple savings equation only serves to emphasize the inverse relationship between the level of outflow and the amount of income generated in the circular flow. Its precise application in reality may lead to gross inaccuracies. Deducting additional income from the corresponding total income, considering other forms of outflow, yields for the most part, personal savings and taxes since imports, business savings and business taxes are derived from consumption expenditures. Hence, the simple equation unnecessarily includes personal taxes as they are not part of national savings but exclude, for the most part, the relevant account of business savings.

SAVINGS-INVESTMENTEQUILIBRIUM

S = Y – CI = Y – C

Therefore, S = Y

Savings-Investment Equilibrium

Increasing, decreasing or maintaining the level of investment expenditure will respectively increase, decrease or maintain the level of income and savings

PRICE LEVEL- affects expenditures and savings

POPULATION GROWTH–change the level of savings

depending on the well-being of the economy

INCOME

TAXES

Determinants of Savings

INVESTMENT RATE - Investment demand is inversely proportional to the

interest rate level with other factors as constant resulting in an investment demand curve that is downward sloping.

ACCELERATION PRINCIPLE-states that the level of investment is a function of

desired changes in output

INNOVATIONS- Joseph Shumpeter describes innovation as the

introduction of an unfamiliar product and untested technology, opening a country’s product to markets and sources of raw material not previously encountered; and the setting up of a new organization in any industry

Investment-Demand Determinants

PROFIT- Profit is the basic reason why a business invests and

profit trends influence business investments in the long run.

EXPECTATIONS- A businessman invests and expects a certain level of

profit.