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Investment
PREPARED BY
UMAIR
Investment Defined
 Investment is any new plant, equipment, additional inventory, computer
software, or residential housing.
 Plant includes factories, office buildings, department and other retail stores,
and shopping malls. Examples of equipment are assembly lines, machine
tools, display cases, cash registers, computer systems, and office
furniture—as long as businesses purchase them.
 For example, if you buy a car for your personal use, it’s a consumption
expenditure. But if Shell Oil buys a car for its executives to ride around in
(on company business), then it’s an investment.
 The key question we must ask is whether the purchase adds to a company’s
plant, equipment, or inventory. If not, then it’s not investment. What if your
town buys a new police car or a new PC or puts up a new school? Is this
investment?
 When the government makes these purchases, it’s government spending
rather than investment
Investment Defined
 What if you were to purchase 100
shares of Intel stock? Would that be
investment?
 Does that add (directly) to Intel’s plant,
equipment, or inventory? It doesn’t?
Then it isn’t investment.
 It’s merely a financial transaction.
 When Intel uses those funds to buy
plant, equipment, or inventory, then it’s
investment.
Investment Defined
 Inventory includes goods on store shelves waiting to be sold, cars in
a showroom or car lot, finished goods in a factory waiting to be
shipped, and even parts of a product ready to be assembled.
 Business firms do not want to hold more inventory than they need
because that inventory ties up money and also incurs storage costs.
 Suppose you owned a toy store and had sales of $10,000 a week.
Would you want to carry an inventory of $100,000 toys?
 Today, with inventory computerization, many firms use the just-in-
time method of inventory control.
 Faster delivery systems —think of UPS and FedEx—also help
companies to keep their inventories lower.
 Stores and factories, many tied to the Internet, have found they can
cut costs by shrinking the warehouses where they store the
materials they use in production or the goods they sell later to
consumers.
Investment Defined
 Calculating inventory investment is a
little tricky.
 We include only the net change from
January 1 to December 31 of a given
year.
 For example, we can calculate how
much was inventory investment for
General Motors in 2003 using the
figures in the followung Table.
Investment Defined
Date Level of Inventory
January 1, 2012 $ 120 million
July 1, 2012 145 million
December 31, 2012 130 million
Hypothetical Inventory Levels of General Motors
Investment Defined
 How much was GM’s inventory
investment in 2012? $25 million?
Nope. $395 million?
 Nope. The answer is $10 million. All
you have to do is look at the levels of
inventory on January 1 and December
31 and calculate the difference.
How does savings gets
invested
 How does savings get invested? A good
question. Well, for starters, what do you do
with the money you save? Put it in the bank?
Buy stocks? Buy corporate bonds?
 Nearly all the money that flows into the stock
market buys stock that has already been
issued.
 So you might buy 500 shares of Cisco, but
someone else has sold those 500 shares.
 However, initial public offerings (IPOs) and
new issues of stock raise money, all of which
goes directly to the corporations issuing
stock.
 And most of that money finances capital
spending.
How does savings gets
invested
 If you deposit your money in a bank, much of
it will end up being invested by large
business borrowers.
 What the banks do is package a large
number of deposits into a much smaller
number of substantial business loans.
 When IBM, Dell, General Motors, and Verizon
come calling on their bankers, they’re going
to borrow hundreds of millions or even
billions of dollars—so much, in fact, that loan
syndicates of dozens of banks are often
formed to raise the total amount needed.
How does savings gets
invested
 Let’s make a clear distinction between “financial”
investment and “real” investment.
 When you buy corporate stocks and bonds, a bank
certificate of deposit (CD), or any other financial
security, you may consider that an investment.
 But economists will tell you that while you made a
personal financial investment, it was not a “real”
investment.
 The only investment that is real to economists is the
purchase of a new home or the purchase by a business
firm of new plant, equipment, or inventory.
 Only “real” investment is counted in GDP.
 Suppose you bought 100 shares of Amazon.com, or
you invested $10,000 in a U.S. Treasury bond, or you
bought part of Rockefeller Center. These were all
investments, right? Wrong!
How does savings gets
invested
 In economics there are only two types of
investment: the purchase of
 (1) new plant, new equipment, and new
residential housing, and
 (2) additional inventory.
 What about all that money you “invested” in
stocks, bonds, and real estate? If those aren’t
investments, what are they? They are
financial transactions—mere exchanges of
assets.
 Now, there’s nothing wrong with these
transactions, but they don’t go into GDP. And
if they don’t, then they’re not investments.
Determinants of Level of
Investment
 Sales Outlook
◦ If you can’t sell your goods or services,
there’s no point in investing, so the ultimate
determinant of the level of investment is the
business firm’s sales outlook.
◦ If business is good and sales are expected to
be strong for the next few months, then
business firms will be willing to take on more
inventory.
◦ And if sales look good for the next few years,
additional plant and equipment will probably
be purchased.
Determinants of Level of
Investment
 Capacity Utilization Rate
◦ The capacity utilization rate is the
percentage of plant and equipment that is
actually being used at any given time.
◦ Since it would be virtually impossible to
use every single factory, office, and piece
of machinery day in and day out, we will
always have some idle plant and
equipment.
Determinants of Level of
Investment
◦ For our purposes, we can count on the
capacity utilization rate as an important
influence on the level of investment in
plant and equipment.
◦ At high rates, companies have
considerable incentive to build more plant
and equipment because sales are
pressing against factory capacity.
◦ During really bad recessions, when
demand is slack, one-third of our factories
and equipment may be idle. Why build
more?
Determinants of Level of
Investment
 The Interest Rate
◦ The interest rate is the cost of borrowing
money.
◦ There are actually many different interest
rates, depending on a firm’s
creditworthiness and the size of the loan.
◦ Suppose you want to borrow $1,000 for
one year and the bank will charge you 12
percent interest.
◦ How much interest will you have to pay if
you borrow the $1,000 for one year?
Determinants of Level of
Investment
Interest rate = Interest paid
Amount borrowed
◦ In general, the lower the interest rate, the
more business firms will borrow.
◦ But to know how much they will borrow—or
whether they will borrow at all in any
particular instance—we need to compare the
interest rate with the expected rate of profit
on the investment.
Determinants of Level of
Investment
 The Expected Rate of Profit
 Economists are not happy unless they give
virtually the same concept at least three
different names.
 Therefore, the expected rate of profit is
sometimes called the marginal efficiency of
capital or the marginal efficiency of
investment.
 We’ll define it this way:
Expected rate of profit = Expected profits
Money Invested
Determinants of Level of
Investment
 Now, of course, we have to work out a
problem.
 Here’s an easy one: How much is the
expected profit rate on a $10,000
investment if you expect to make a
profit of $1,650?
 It will be 16.5%.
Determinants of Level of
Investment
 Keynes said that every profit
opportunity would be exploited as long
as the expected profit rate (which he
called the “marginal efficiency of
capital”) exceeded the interest rate:
 “The rate of investment will be
pushed to . . . where the marginal
efficiency of capital in general is equal
to the market rate of interest.”
Determinants of Level of
Investment
 Suppose your business firm is interested
in borrowing $100,000 at the going
interest rate of 15 percent to buy
inventory.
 If your expected profit rate is 18 percent,
would it pay to borrow?
 In other words, after you paid off the
interest, how much money would you
have left?
 $18,000 - $15,000 in interest = $3,000.
 You would stand to make $3,000 profit.
 Of course you would borrow the money.
Autonomous Investment
 It is the investment expenditure
considered independent of the level of
income.
 It is called planned investment.
Autonomous Investment
 While autonomous investment expenditures
are unaffected by income and are held
constant for the construction of the
investment line, they are not absolutely
constant, they do change.
 Autonomous investment is affected by
investment expenditures determinants, such
as interest rates, expectations, technology,
and capital prices.
 Changes in these and other determinants
cause changes in autonomous investment,
which shift the investment line as well as the
aggregate expenditures line and disrupt
whatever equilibrium might exist.
Induced Investment
 It is the part of the investment which is
influenced by the level of income.
 When production and income change,
some adjustment of expenditures
needs to be made, and that
adjustment is in the form of induced
investment.
Autonomous and Induced
Investment
Investment Function
 One way to provide an illustration of
autonomous investment (and the relation to
induced investment) is with a general linear
investment equation, such as the one
presented here: I = e + fY
 where: I is investment expenditures, Y is
income (or aggregate production), e is the
intercept, and f is the slope.
 The two key parameters that characterize this
investment equation are slope and intercept.
 Autonomous investment is indicated by the
intercept of the investment equation.
 Induced investment is then indicated by the
slope.
Investment Function
An Autonomous Intercept:
 The intercept of the investment equation
(e) measures the amount of investment
undertaken if income is zero.
 If income is zero, then investment is $e.
 The intercept is generally assumed and
empirically documented to be positive (0
< e).
 It is conceptually identified as
autonomous investment.
Investment Function
An Induced Slope:
 The slope of the investment equation (f)
measures the change in investment
resulting from a change in income.
 If income changes by $1, then
investment changes by $f.
 This slope is generally assumed and
empirically documented to be greater
than zero, but less than one (0 < f < 1).
 It is conceptually identified as induced
investment and the marginal propensity
to invest (MPI).

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Investment Guide

  • 1.
  • 3. Investment Defined  Investment is any new plant, equipment, additional inventory, computer software, or residential housing.  Plant includes factories, office buildings, department and other retail stores, and shopping malls. Examples of equipment are assembly lines, machine tools, display cases, cash registers, computer systems, and office furniture—as long as businesses purchase them.  For example, if you buy a car for your personal use, it’s a consumption expenditure. But if Shell Oil buys a car for its executives to ride around in (on company business), then it’s an investment.  The key question we must ask is whether the purchase adds to a company’s plant, equipment, or inventory. If not, then it’s not investment. What if your town buys a new police car or a new PC or puts up a new school? Is this investment?  When the government makes these purchases, it’s government spending rather than investment
  • 4. Investment Defined  What if you were to purchase 100 shares of Intel stock? Would that be investment?  Does that add (directly) to Intel’s plant, equipment, or inventory? It doesn’t? Then it isn’t investment.  It’s merely a financial transaction.  When Intel uses those funds to buy plant, equipment, or inventory, then it’s investment.
  • 5. Investment Defined  Inventory includes goods on store shelves waiting to be sold, cars in a showroom or car lot, finished goods in a factory waiting to be shipped, and even parts of a product ready to be assembled.  Business firms do not want to hold more inventory than they need because that inventory ties up money and also incurs storage costs.  Suppose you owned a toy store and had sales of $10,000 a week. Would you want to carry an inventory of $100,000 toys?  Today, with inventory computerization, many firms use the just-in- time method of inventory control.  Faster delivery systems —think of UPS and FedEx—also help companies to keep their inventories lower.  Stores and factories, many tied to the Internet, have found they can cut costs by shrinking the warehouses where they store the materials they use in production or the goods they sell later to consumers.
  • 6. Investment Defined  Calculating inventory investment is a little tricky.  We include only the net change from January 1 to December 31 of a given year.  For example, we can calculate how much was inventory investment for General Motors in 2003 using the figures in the followung Table.
  • 7. Investment Defined Date Level of Inventory January 1, 2012 $ 120 million July 1, 2012 145 million December 31, 2012 130 million Hypothetical Inventory Levels of General Motors
  • 8. Investment Defined  How much was GM’s inventory investment in 2012? $25 million? Nope. $395 million?  Nope. The answer is $10 million. All you have to do is look at the levels of inventory on January 1 and December 31 and calculate the difference.
  • 9. How does savings gets invested  How does savings get invested? A good question. Well, for starters, what do you do with the money you save? Put it in the bank? Buy stocks? Buy corporate bonds?  Nearly all the money that flows into the stock market buys stock that has already been issued.  So you might buy 500 shares of Cisco, but someone else has sold those 500 shares.  However, initial public offerings (IPOs) and new issues of stock raise money, all of which goes directly to the corporations issuing stock.  And most of that money finances capital spending.
  • 10. How does savings gets invested  If you deposit your money in a bank, much of it will end up being invested by large business borrowers.  What the banks do is package a large number of deposits into a much smaller number of substantial business loans.  When IBM, Dell, General Motors, and Verizon come calling on their bankers, they’re going to borrow hundreds of millions or even billions of dollars—so much, in fact, that loan syndicates of dozens of banks are often formed to raise the total amount needed.
  • 11. How does savings gets invested  Let’s make a clear distinction between “financial” investment and “real” investment.  When you buy corporate stocks and bonds, a bank certificate of deposit (CD), or any other financial security, you may consider that an investment.  But economists will tell you that while you made a personal financial investment, it was not a “real” investment.  The only investment that is real to economists is the purchase of a new home or the purchase by a business firm of new plant, equipment, or inventory.  Only “real” investment is counted in GDP.  Suppose you bought 100 shares of Amazon.com, or you invested $10,000 in a U.S. Treasury bond, or you bought part of Rockefeller Center. These were all investments, right? Wrong!
  • 12. How does savings gets invested  In economics there are only two types of investment: the purchase of  (1) new plant, new equipment, and new residential housing, and  (2) additional inventory.  What about all that money you “invested” in stocks, bonds, and real estate? If those aren’t investments, what are they? They are financial transactions—mere exchanges of assets.  Now, there’s nothing wrong with these transactions, but they don’t go into GDP. And if they don’t, then they’re not investments.
  • 13. Determinants of Level of Investment  Sales Outlook ◦ If you can’t sell your goods or services, there’s no point in investing, so the ultimate determinant of the level of investment is the business firm’s sales outlook. ◦ If business is good and sales are expected to be strong for the next few months, then business firms will be willing to take on more inventory. ◦ And if sales look good for the next few years, additional plant and equipment will probably be purchased.
  • 14. Determinants of Level of Investment  Capacity Utilization Rate ◦ The capacity utilization rate is the percentage of plant and equipment that is actually being used at any given time. ◦ Since it would be virtually impossible to use every single factory, office, and piece of machinery day in and day out, we will always have some idle plant and equipment.
  • 15. Determinants of Level of Investment ◦ For our purposes, we can count on the capacity utilization rate as an important influence on the level of investment in plant and equipment. ◦ At high rates, companies have considerable incentive to build more plant and equipment because sales are pressing against factory capacity. ◦ During really bad recessions, when demand is slack, one-third of our factories and equipment may be idle. Why build more?
  • 16. Determinants of Level of Investment  The Interest Rate ◦ The interest rate is the cost of borrowing money. ◦ There are actually many different interest rates, depending on a firm’s creditworthiness and the size of the loan. ◦ Suppose you want to borrow $1,000 for one year and the bank will charge you 12 percent interest. ◦ How much interest will you have to pay if you borrow the $1,000 for one year?
  • 17. Determinants of Level of Investment Interest rate = Interest paid Amount borrowed ◦ In general, the lower the interest rate, the more business firms will borrow. ◦ But to know how much they will borrow—or whether they will borrow at all in any particular instance—we need to compare the interest rate with the expected rate of profit on the investment.
  • 18. Determinants of Level of Investment  The Expected Rate of Profit  Economists are not happy unless they give virtually the same concept at least three different names.  Therefore, the expected rate of profit is sometimes called the marginal efficiency of capital or the marginal efficiency of investment.  We’ll define it this way: Expected rate of profit = Expected profits Money Invested
  • 19. Determinants of Level of Investment  Now, of course, we have to work out a problem.  Here’s an easy one: How much is the expected profit rate on a $10,000 investment if you expect to make a profit of $1,650?  It will be 16.5%.
  • 20. Determinants of Level of Investment  Keynes said that every profit opportunity would be exploited as long as the expected profit rate (which he called the “marginal efficiency of capital”) exceeded the interest rate:  “The rate of investment will be pushed to . . . where the marginal efficiency of capital in general is equal to the market rate of interest.”
  • 21. Determinants of Level of Investment  Suppose your business firm is interested in borrowing $100,000 at the going interest rate of 15 percent to buy inventory.  If your expected profit rate is 18 percent, would it pay to borrow?  In other words, after you paid off the interest, how much money would you have left?  $18,000 - $15,000 in interest = $3,000.  You would stand to make $3,000 profit.  Of course you would borrow the money.
  • 22. Autonomous Investment  It is the investment expenditure considered independent of the level of income.  It is called planned investment.
  • 23. Autonomous Investment  While autonomous investment expenditures are unaffected by income and are held constant for the construction of the investment line, they are not absolutely constant, they do change.  Autonomous investment is affected by investment expenditures determinants, such as interest rates, expectations, technology, and capital prices.  Changes in these and other determinants cause changes in autonomous investment, which shift the investment line as well as the aggregate expenditures line and disrupt whatever equilibrium might exist.
  • 24. Induced Investment  It is the part of the investment which is influenced by the level of income.  When production and income change, some adjustment of expenditures needs to be made, and that adjustment is in the form of induced investment.
  • 26. Investment Function  One way to provide an illustration of autonomous investment (and the relation to induced investment) is with a general linear investment equation, such as the one presented here: I = e + fY  where: I is investment expenditures, Y is income (or aggregate production), e is the intercept, and f is the slope.  The two key parameters that characterize this investment equation are slope and intercept.  Autonomous investment is indicated by the intercept of the investment equation.  Induced investment is then indicated by the slope.
  • 27. Investment Function An Autonomous Intercept:  The intercept of the investment equation (e) measures the amount of investment undertaken if income is zero.  If income is zero, then investment is $e.  The intercept is generally assumed and empirically documented to be positive (0 < e).  It is conceptually identified as autonomous investment.
  • 28. Investment Function An Induced Slope:  The slope of the investment equation (f) measures the change in investment resulting from a change in income.  If income changes by $1, then investment changes by $f.  This slope is generally assumed and empirically documented to be greater than zero, but less than one (0 < f < 1).  It is conceptually identified as induced investment and the marginal propensity to invest (MPI).