Investment: Concepts

 In general sense Investment means to buy shares, stocks,

bonds and securities which are already existing in stock market.

 But this is not real investment because it is simply a transfer of

existing assets.

 Hence this is called financial investment which does not affect

aggregate spending.

 In Keynesian terminology investment refers to real investment

which adds to capital equipment.
 CONT….
 Stock-A collection of goods held by an individual or entrepreneur

 Share-A part of the ownership of a company held by an individual or

entrepreneur

 Security- A paper asset where both party are agree upon certain
conditions.

 Bond-When a company or the government raises a loan from the investing

public in contrast to the raising of the share capital, the document against
which such a loan is raised is called bond.

 Purchaser of the bond is called the bond holder who gets a certain rate of
interest and is entitled to get back the loan at maturity.

2
 CONT…
 Debentures- A secured loan raised by a company usually with
fixed interest and some times with a fixed redemption date.

 Debentures holders have no control over the company so long

as their interest is paid and all conditions are fulfilled.

 But if the interest is not paid or the conditions are broken they
can take control of the company and they rank before share
holder.

3
 CONT….
 It leads to increase in level of income and production by increasing the
production and purchase of capital assets.

 Investment thus includes new plant, equipment, construction of public works

like dams, roads, buildings etc.

 According to Joan Robinson “By investment we mean an additional to capital;

such as occurs when a new house is built or a new factory is built.

 In other words investment means making an additional to the stock of goods

in existence.
 CONT….
 Capital, on the other hand, refers to real assets like factories, plants,
equipment and inventories of finished and semi-finished goods.

 It is any previously produced input that can be used in the production

process to produce other goods.

 To be more precise, investment is the production of real capital asset during

any period of time.

 To illustrate, suppose the capital assets of a firm on 31 March 2009 are Rs

100 crores and it invests at the rate of Rs 10 crores during the year 2009-
2010. At the end of the next year(2010 March 31) its total capital will be Rs
110 crores. Symbolically, let I be investment and K be capital in year t, then
It= Kt-Kt-1.
 CONT….
Capital and investment are related to each other through net investment

Gross Investment is the total amount spent on new capital assets in a year

But some capital stock wears out every year and is used up for depreciation

Net investment is gross investment minus depreciation and obsolescence

charges(or replacement investment).

If gross investment equals depreciation, net investment is zero and there is
no addition to the economy’s capital stock.

If gross investment is less than depreciation, there is disinvestment in the

economy and the capital stock decreases.

Thus for an increase in the real capital stock of the economy, gross
6
investment must exceed depreciation.
 Types of Investment
 Induced Investment
 Autonomous Investment
 
 Induced Investment – Investment done for profit.
 Induced investment is profit or income motivated
 Factor like prices, wages and interest changes which affect profits,
influence induced investment.
 Induced investment may be further divided into types

 Average Propensity to Invest(API)=I\Y

 Marginal Propensity to Invest(MPI)=∆I\ ∆Y

7
8
 CONT…..
 Average Propensity to Invest (API)- It is the ratio of investment to income i.e.
,I/Y.
Marginal Propensity to Invest (MPI)- It is the ratio of change in investment to
change in income i.e. , ∆I\ ∆Y.

Autonomous Investment-It is independent of the level of income and thus income

inelastic.
It is influenced by exogenous factors like innovation, inventions, growth of
population and labour force, research, social and legal institutions, weather
changes, war, revolution, etc.
Investment in economic and social overheads whether made by the government
or private enterprise is autonomous.
Such investment includes expenditure on buildings, dams, roads, canals,
schools, hospitals, etc. 9
 Determinants of Investment
 The decision to invest in a new capital asset depends on whether the
expected rate of return on the new investment is equal to or greater or less
than the rate of interest to be paid on the funds needed to purchase this asset.
 It is only when the expected rate of return is higher than the interest rate that
investment will be made in acquiring new capital assets.
 In reality, there are three factors that are taken into consideration while
making any investment decision. They are
o Cost of capital asset

o The expected rate of return from it during its lifetime &

o Market rate of interest

 Keynes sums up these factors in his concept of the Marginal Efficiency of

Capital
10
 CONT……
 Marginal Efficiency of Capital(MEC)-It is the highest rate of return
expected from an additional unit of a capital asset over its cost.
 According to Khurihara, “it is the ratio between the prospective yield of
additional capital goods and their supply price”.
 Prospective Yield-Aggregate net return from an asset during its life time

 Supply Price-It is the cost of producing this asset

 If the supply price of a capital asset is Rs 20,000 and annual yield is Rs

2000 then MEC of this asset is 2000/20000=0.1 or 10%.
 Thus the Marginal efficiency of capital is the percentage of profit expected
from a given investment on capital asset.

11
 Relation between MEC and ROI
 If MEC > ROI= There will be a tendency to borrow funds in order to invest in
new capital .
I
 If MEC < ROI= No firm will borrow funds in order to invest in new capital

 If MEC = ROI= The equilibrium condition for a firm to hold the optimum
capital stock

 Any disequilibrium between the MEC and ROI can be removed by changing
the capital stock

12
 Marginal Efficiency of Investment(MEI)

 MEI is the rate of return expected from a given investment on capital asset
after covering all its costs, except the rate of return.

 Like the MEC , it is the rate which equates the supply price of a capital asset
to its prospective yield.
M

13
 Multiplier
The concept was first developed by R.F. Khan in his famous article
“The relation of home investment to unemployment of June 1931.

That is why it is know as Employment Multiplier.

Keynes took the idea from khan and formulate investment multiplier

K= ∆Y\ ∆I

The value of Multiplier depend on MPC

K=1/1-C

14
 Assumptions of Multiplier
MPC is constant
Consumption is a function of Current income
There is no time lag in Multiplier process that means
an increase in investment instantaneously leads to a
multiplier increase in income
There is a closed economy implying the absence of
international trade.
There is no change in price of commodities
The situation of less than full employment prevails in
the economy
Multiplier process operates in the industrialized
economy
15
 Multiplier
 Forward Working of Multiplier

Backward Working of Multiplier

A reduction in investment leads to contraction in
income and consumption which in turn causes
cumulative decline in income and consumption.

Higher the MPC , greater the value of Multiplier and

greater the cumulative decline in income.

In other wards, higher the MPS, lower is the size of the
multiplier and smaller the cumulative decline in income16
 Leakages of Multiplier
Saving

Debt Cancellation

Import

Price Inflation

Hoarding

Purchase of Old Share and Securities

Taxation

Undistributed Profits 17
 Criticisms of Multiplier
Neglect of Time lags

Assumption of consumption function

Acceleration effect Ignored

Saving is not Hoarding

18
 Dynamic Version of Multiplier
Keynes logical theory of the multiplier is an
instantaneous process without time lag.
It is a timeless static equilibrium analysis in which the
total effect of a change in investment on income is
instantaneous
So that consumption goods are produced
simultaneously and consumption expenditure is also
incurred instantaneously.
19
 CONT..
The dynamic multiplier relates to the time lags in the
process of income generation.
The series of adjustments in income and consumption
may take months or even years for multiplier effect


20
 CONT…
 MPC=0.5

 So K=1/1-0.5=2

 Suppose that investment is increased by Rs 100 Crores

 Out of this Rs 100 crores, Rs 50 crores saved and Rs 50

crores are spent on consumption
 The induce consumption of Rs 50 c leads to an increase in
income by same amount in period 2.
 In same manner income increases by Rs 25 crores in
period 3 and Rs 12.5 crores in period 4 and so on till the
total income has increased by Rs. 200 c 21
 Multiplier
Period Change in Change in Change in Change in
Investment Income Consumption Saving
1 100 100 50 50

2 - 50 25 25

3 - 25 12.5 12.5

4 - 12.5 6.25 6.25

. . . . .

. . . . .

& so on . . . .

Total 100 200 100 100

22
 CONT…
 Limit of multiplier 1 to ∞
Forward Operation
Backward Operation
 Static Version
 Dynamic Version

23
 Acceleration Principle

A
The principle of Acceleration was first introduced by J.M. clark.
 This principle explains the process by which an increase (decrease)
in demand for consumption goods leads to an increase (decrease) in
investment on capital goods
 According to Prof. Kurihara “ The accelerator coefficient is the ratio
between induced investment and initial change in consumption
expenditure.
 Symbolically β= ∆I\ ∆C………………………….(1) {Samuelson View}

 ∆I= β ∆C………………….(2)

 Where β is the Accelerator coefficient, ∆I is net change in investment

& ∆C is the net change in consumption expenditure.

24
 Acceleration Principle

A
If the increase in consumption expenditure of Rs 10 crores leads to an
increase in investment of Rs 30 crore, the accelerator coefficient is 3
 In an economy , the required stock of capital depends on the change
in the demand for output.
 Any change in output will lead to a change in capital stock.

 This change equals v times the change in output

 Thus ∆I= v ∆Y, Where v is accelerator.

 If a machine has a value of Rs 4 lakh and produces output worth Rs 1

lakh, then the value of v is 4.
 An entrepreneur who wishes to increase his output by Rs 1 lakh every
year must invest Rs 4 lakh on his machine.

25
 Acceleration Principle

A
This equally applies to an economy where if the value of the
accelerator is greater than one, more capital is required per unit of out
put .
 Gross investment in the economy will equal replacement investment
(depreciation and obsolescence)plus net investment.
 The acceleration principle can be expressed in the form of the
following equation

 Igt=v(Yt-Yt-1)+R………………(3)

 Igt=v ∆ Yt+R

 The equation tells that gross investment during period t depends on

the change in output Y from period t-1 to period t multiplied by the
accelerator(v) plus replacement investment R.
26
 Acceleration Principle

A
That is why this theory more broadly interpreted by Hicks as the ratio
of investment to output
 V= ∆ I/ ∆ Y ………………(4)

 Int= v(Yt-Yt-1)

 Int= v ∆ Y…………..(5)

 Equation 1 and 4 are same

 In Hicks’s model net investment Int= v(Yt-Yt-1) while in samuelson’s

model Int= β(Ct-Ct-1) .

 If Yt>Yt-1 net investment is positive during period t

 If Yt<Yt-1 net investment is Negative or disinvestment in period t

27
 Operation of the theory
Period Total Output Required Cap. Repl. Inv. Net. Inv. Gross Inv.

1 2 3 4 5 = 6

t 100 400 40 0 40

t+1 100 400 40 0 40

t+2 105 420 40 20 60

t+3 115 460 40 40 80

t+4 130 520 40 60 100

t+5 140 560 40 40 80

t+6 145 580 40 20 60

t+7 140 560 40 -20 20

t+8 130 520 40 -40 0

t+9 125 600 40 -20 20

28
 Reference Books
Foreign Author
 Principle of Macro Economics by Mankiw

 Macroeconomics theory and policy by William Branson

 Macroeconomics by R. Dornbusch, S. Fisher & R. Stantz

 Lectures on Macroeconomics by O.J. Blanchard & S.Fisher

Indian author
 Macroeconomics theory and policy by D.N. Dwivedi

 Macroeconomics for management students by A. Nag

 Macroeconomic theory by M.C. Vaish

29
T H A N K Y O U

30