INVESTMENT DECISIONS

Prof T Prabhakar Reddy

The Multiplier
The concept of multiplier plays an important role in the income determination process. This determines how or more specifically by what amount income increases as the result of an increase in the level of investment.

The multiplier or the investment income multiplier as it is sometimes described, is in short, the ratio of Y to Investment. The ratio is always greater than investment. hence, the use of the expression multiplier. The multiplier shows the impact of an increase in investment on income through the savings function and therefore, through the consumption function.

Investment and the Rate of Interest

The decision to invest depends on whether or not the expected rate of return on investment is greater than the cost of borrowing the necessary funds; or If the funds are already available whether the expected returns are higher than interest earned by lending out the funds.

The decision to invest in a machine for example depends upon whether or not the investment is expected to yield more revenue over its lifetime than it costs to purchase and operate (total profits)

If the rate of return is r and r is greater than I then the machine should be purchased even if it is necessary to borrow the funds. But how do we determine r?

r on any investment is simply the discount rate which exactly equates the value of all expected future earnings to the cost of the machine. We say that C=R1/(1+r)+R2/(1+r)2

As long as the MEC(r)is greater than the rate of interest (i) or as long as the present value of the stream of future earnings (V) exceeds the cost (c) investment should take place.

Acceleration principle
National income is an important determinant of the level of investment. It may be more appropriate to say that changes in the level of income is a more direct determinant of the level of investment. This is stated by AP. It=f(Ot-Ot-1)

The AP implies that output or income must keep growing if net investment is to be positive. If output stabilizes even at a high level net investment will become zero.

The Business Cycles

There are periods of flourishing activity leading to prosperity and growth. There are also periods of recession which lead to decline in output and employment. Usually periods of prosperity and recession alternate in some cyclical pattern.

Prosperity or boom is generally followed by downswing and recession which are in turn followed by recovery leading to a new boom. Such fluctuations in national income, employment, investment and related macro economic aggregates are called business cycles.

The Business Cycles

According to Keynes, a (business) cycle consists of expansions occurring at about the same time in many economic activities followed by similarly general recessions, contractions and revivals which merge with the expansion phase of the next cycle; this sequence of change is recurring but not periodic.

The Business Cycles

By a cyclical movement we mean that as the system progresses in e.g., the upward direction, the forces propelling it upward first gather force and have a cumulative effect on one another but gradually lose their strength until at a certain point, they tend to be replaced by forces operating in the opposite direction which in turn gather forces

And accentuate one another and until they too, having reached their maximum development, wane and give place to their opposite. We do not however merely mean by a cyclical movement that upward and downward tendencies once started do not persist for ever in the same direction but are ultimately reversed;

The Business Cycles

We also mean that there is some recognizable degree of regularity in the time sequence and duration of the upward and downward movements.

The Business Cycles

The phases Expansion Peak Recession Trough

Expansion is characterized by a high level of economic activity and is also referred to as the period of prosperity or boom. It implies a continuous upward movement. This comes to an end and passes into the recession phase at the upper turning point or peak.

During recession, production, employment, investment, prices, profit etc., show a continuous downward movement till the recession phase gives way to the expansion phase at the lower turning point or trough. Thus four phases of the cycle keep alternating themselves.

Schumpeterian cycle
Prosperity Recession Depression Recovery

Schumpeterian cycle
In the prosperity phase employment continues to increase but a diminishing rate till the cycle peak is reached. In the recession phase, employment decreases at an accelerating rate till point B is reached.

Schumpeterian cycle
After this, the cycle moves into the lower half. In the depression phase employment continues to fall but the rate of fall gradually decreases till the cycle trough is reached. In the recovery phase employment continues to increase at an increasing rate till point C is reached.