Chapter 6 -The Investment Function

3. Investment Expenditure – It is a capital
spending mainly derived not from current
income and consumption but from
accumulated savings and other sources
external to the circular flow.
It should be noted that investment
spending, which is for long-term
consumption, is not the monopoly of
business since households and government
do as well.

4. The following equations illustrate how the
investment factor is incorporated in the
income function with the multiplier process:
Where:
y = Income
C = Consumption
I = Investment
M = Multiplier
∆ = Change
The equations further imply
that investment is directly
proportional to income.
∆y = IM
∆y = I + ∆C
Since initially:
y = C
Therefore:
y = C + ∆C + I
y = C + I

6. 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.
1. 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.
2. Every phase in setting up a capital base may not be
capable of independent utilization until the
completion of the other phases.

7. Despite the investment-production time lag,
sustained investment patterns can determine
trends in the capital stock and production level over
a long period.
The following framework illustrates
investment-output relationship assuming a short-
run time frame, no investment-production time lag,
and constant capital output ratio.
Kf = (Ki − D + I)
Yf = (Yi - ∆yd + ∆yi) = a(Ki - D + I)

8. 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 depreciation
and investment
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 ration (Y/K)

9. Furthermore:
Net change in capital stock
= (-D + I)
Net change in output
= (-∆yd + ∆yi)

11. Savings – It is the unspent portion of income
during the period intended for spending.
Savings of the economy can be simply
expressed as follows assuming that it is the
only determinant of the multiplier.
S = Y – C
Where:
S = Savings
Y = Income
C = Consumption

12.  Going back to the new income equation,
Y = C + I
Y – C = I
S = I
Assuming that income is now fully generated,
(S = I) means completing the process of
transforming the investment inflow into savings
outflow which gradually reduces the additional
income that the system generates. In essence, what
goes in will then come out of the circular flow in the
forms of savings, taxes, and imports.

13. Price Level Population Growth

15. Interest Rate
Investment
demand is inversely
proportional to the
interest rate level with
other factors as
constant (ceteris
paribus) resulting in an
investment demand
curve that is downward
sloping.
The Acceleration Principle
The principle
states that the level of
investments is a
function of desired
changes in output. This
change in investment
constitutes a shift in
the investment demand
curve.

16. Innovations
 It can create demand for
products including capital
goods and usher the
acceleration process between
income and investment.
Joseph Schumpeter
 A noted development
economist in contemporary
times.
 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.

17. Profit
 It is the basic reason why
a business invests and,
therefore, it trends
influence business
investments in the long-
run.
Expectations
 A businessman invests and
expects a certain level of
profit given a certain
influence of the business
environment.

18. Local supply-demand constraints
may induce the economy to tap
external sources of funds which
traditionally was the case in the
Philippines because of the unrealistic
interest rate ceilings pegged by the
government in the 70’s and 80’s.

21. Recovery
Increase in Real GNP.
Increases in employment, income, production,
capacity utilization, and price.
Boom – The peak of recoveries upturn.
Recession – follows recovery with reverse
trends in employment, income, production,
capacity utilization, and price.
Depression – It is when the economy
reaches the rock bottom.

22. a) Price level is constant implying that variations in the
desired expenditure level indicate changes in the desired
production level.
b) Ratio of expenditure to capital stock is equal to 2.
c) Price of capital is equal to 2.
d) Marginal propensity to consume is 0.50 and, therefore, the
multiplier is 2.
e) Periodic replacement in the capital stock is 5.
f) Replacement of additions to the capital stock because of
depreciation only takes effect after 4 periods.
g) No investment-output time lag.
h) A change in the level of investment expenditure only
affects income in the subsequent period.