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 investmentClassified into three categories: Fixed non-residential investment Inventory investment Fixed residential investments
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 timePoint 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 ofInvestmentPrivate 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 constantMEC determines the volume of investmentin a communityFluctuations in investment are mainly dueto fluctuations in MEC
MEC The expected profitability of a capital assetDefinition: 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)nWhere Cr = supply price of new capital assetR1, R2 ---- = expected annual returnsr = 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
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
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, µ)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 deriveddemand - will vary positively with changesin incomeInterest rate: investment has negativerelationship 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