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form of interest, income, or appreciation of the value of the instrument. It is related to saving or deferring consumption. Investment is involved in many areas of the economy, such as business management and finance no matter for households, firms, or governments. An investment involves the choice by an individual or an organization such as a pension fund, after some analysis or thought, to place or lend money in a vehicle, instrument or asset, such as property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the foreign asset denominated in foreign currency, that has certain level of risk and provides the possibility of generating returns over a period of time. Investment comes with the risk of the loss of the principal sum. The investment that has not been thoroughly analyzed can be highly risky with respect to the investment owner because the possibility of losing money is not within the owner's control. The difference between speculation and investment can be subtle. It depends on the investment owner's mind whether the purpose is for lending the resource to someone else for economic purpose or not. In the case of investment, rather than store the good produced or its money equivalent, the investor chooses to use that good either to create a durable consumer or producer good, or to lend the original saved good to another in exchange for either interest or a share of the profits. In the first case, the individual creates durable consumer goods, hoping the services from the good will make his life better. In the second, the individual becomes an entrepreneur using the resource to produce goods and services for others in the hope of a profitable sale. The third case describes a lender, and the fourth describes an investor in a share of the business. In each case, the consumer obtains a durable asset or investment, and accounts for that asset by recording an equivalent liability. As time passes, and both prices and interest rates change, the value of the asset and liability also change. An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of getting a future return or interest from it. The word originates in the Latin "vestis", meaning garment, and refers to the act of putting things (money or other claims to resources) into others' pockets.. The basic meaning of the term being an asset held to have some recurring or capital gains. It is an asset that is expected to give returns without any work on the asset per se. The term "investment" is used differently in economics and in finance. Economists refer to a real investment (such as a machine or a house), while financial economists refer to a financial asset, such as money that is put into a bank or the market, which may then be used to buy a real asset.
capital is a stock— that is. Non-residential fixed investment (such as new factories) and residential investment (new houses) combine with inventory investment to make up I. r). In measures of national income and output. Net fixed investment is the value of the net increase in the capital stock per year. the interest rate represents an opportunity cost of investing those funds rather than lending out that amount of money for interest. whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. The time dimension of investment makes it a flow. The logic is that without bank deposits. Inventory investment refers to the accumulation of goods inventories. is not capital. gross investment (represented by the variable I) is also a component of Gross domestic product (GDP). Even if a firm chooses to use its own funds in an investment. I = GDP . Investment is often modeled as a function of Income and Interest rates.C . Examples include railroad or factory construction. . G is government spending. accumulated net investment to a point in time (such as December 31). There is an important economic idea that Savings = Investment. and net exports are subtracted (i. By contrast. where C is consumption. given in the formula GDP = C + I + G + NX. Net investment deducts depreciation from gross investment. and it can be intended or unintended. An economy with a low savings ratio has little funds to finance investment because it is all being used to finance current consumer spending.e. Fixed investment.In economics or macroeconomics In economic theory or in macroeconomics. An increase in income encourages higher investment. given by the relation I = f(Y. banks are not in a position to lend money for investment. Investment in human capital includes costs of additional schooling or on-the-job training. Thus investment is everything that remains of total expenditure after consumption. investment is the amount purchased per unit time of goods which are not consumed but are to be used for future production.G NX). government spending. it can be positive or negative. and NX is net exports. Factors that determine levels of investment in the economy Saving and Investment. as expenditure over a period of time ("per year").
When interest rates are reduced. Japanese firms investing in the UK. higher levels of saving do not necessarily lead to more investment. which gives a .However. In the great depression. So reducing interest rates does not by itself improve economic performance. The extra saving may not encourage people to invest more. UK has a current account deficit but. the UK has also been able to attract capital investment from abroad e. extra savings are important for financing extra investment. and other consumer loans become cheaper. and consumers will have less disposable income. This is perhaps why full employment is important. The movement of interest rates is of course one of the most fundamental factors affecting investment decisions. and consequently is a study of the behaviour of people.g. when the economy is close to full employment.g. The reason for this is that investment decisions are affected by much more than interest rates. On the other hand. what we are hoping to do is influence the behaviour of individuals. When we change monetary policy to influence economic outcomes. extra savings may just be saved and not used to finance resources. If rates go up. then the currency becomes more attractive to hold relative to another. The fact is that even if interest rates were to be reduced by 5%. a rise in interest rates is unfriendly for real investments as it means that as an option. Keynes called this the paradox of thrift Keynes said that an important factor in determining investment was. but peoples attitude to the future of the economy. as the returns on holding the currency is greater. not so much levels of savings. From the consumer’s perspective. lower interest rates means that mortgages. and other monetary policy. if rates decrease then it means that financing for a business becomes less expensive. Similarly. individual savings did not encourage investment. We have to remember that economics is a social science. However. it is expected to have the result of affecting people’s investment decisions. E. as it is hoped that an individual will want to borrow money at the lower cost and invest it in real businesses. borrowing money becomes more expensive. In a recession. and this will encourage business activity. there would still be limited uptake in corresponding investments. Consumers will take advantage of the less expensive money to improve their life styles by buying new houses and motor vehicles. Another factor is financing investment from abroad.
The reason why a rate reduction will have the intended effect therefore is because individuals will react in the desired way. The significance of the concept to a business firm is that projects whose marginal efficiency of capital exceeds the market rate of interest are profitable to undertake. it would not pay to undertake a project that has a return of 91⁄2%. and rate of return over cost. This occurs because of the law of diminishing returns as it applies to the yield on capital. net capital productivity. thus increasing exports. resulting in the relative price of goods produced being cheaper. but any return over 10% would be acceptable. natural interest rate. available capital moves into lower yielding projects and interest rates decline. Thus demand for debt financing will increase. It is also known as marginal productivity of capital. marginal efficiency of capital influences longterm interest rates. In a larger economic sense. . investors are able to justify projects that were previously uneconomical. natural interest rate. As market rates fall. Annual percentage yield earned by the last additional unit of capital. The marginal efficiency of capital . for example. Lower rates will also cause the currency to devalue The marginal efficiency of capitalagainst that of major trading partners (assuming their rates do not change). and rate of return over cost. What we need to ascertain then is what is it that influences this reaction from individuals? In the US. when the Fed wants consumers to increase economic activity and drive new investments they will lower interest rates. Annual percentage yield earned by the last additional unit of capital. If the market rate is 10%. The decision to invest in a new capital asset depends on wether 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 The significance of the concept to a business firm is that it represents the market rate of interest at which it begins to pay to undertake a capital investment. also known as marginal productivity of capital. This process is called diminishing marginal productivity or declining marginal efficiency of capital. net capital productivity. When these funds are accessed then individuals will look at the investment options available and invest in ventures that will give them a consistently higher return than the cost of the borrowed funds. As the highest yielding projects are exhausted. And this is what happens in countries such as the US and UK. for example. Lower rates will mean reduced funding costs for businesses and consumer purchases.higher return than the cost of the funds borrowed.
The new desired amount of equipment will also rise by 5%. . for example. However. a small percentage change (either an increase or decrease) in final sales can lead to a big percentage change in investment. Thus if firms desire a constant capitalto-output ratio. a marginal percentage change in the sale of products can result to a higher percentage change in investment. Now suppose that the sales of shoes jumps by 5%. via the multiplier effect. which is an integral part of business cycle theories that are still used today. net investment is a function of the alteration in output. Suppose further that each year one tenth of the equipment wears out. Consequently. total investment each year will be $100.Accelerator principle The accelerator principle defines the growth in output that would induce a continuation in net investment. In such a case.) This may lead to further growth of the economy through the stimulation of consumer incomes and purchases. all for replacement.050 annually. i. to $1050 each year. and each year one tenth of its equipment wears out. if a commercial entity producing leather bags invests $1. The accelerator principle has played an important role in defining the fluctuations in investment. It played a role in many business-cycle theories and is still used today to explain some of the fluctuation in investment. if the sale of leather bags increases by 5% to $1. the total investment will increase by 50% to $150 to achieve the desired level. to $1050. investment will have to increase by 50%. In other terms. This usually implies that profit expectations and business confidence rise. by a change in Gross National Product). If there is no growth or decline. encouraging businesses to build more factories and other buildings and to install more machinery. the total investment for replacement would be $100 assuming that there is no growth or decline.000 worth of equipment to produce $1. that normally it takes $1000 worth of equipment to manufacture $1000 worth of shoes each year. increased sales and cash flow.e. to obtain this new level.. The accelerator effect in economics refers to a positive effect on private fixed investment of the growth of the market economy (measured e. the amount of equipment will also rise by 5% to $1050. (This expenditure is called fixed investment. Suppose. The accelerator principle says that small changes in consumer spending can cause big percentage changes in investment. Rising GNP (an economic boom or prosperity) implies that businesses in general see rising profits. to $150.g. and greater use of existing capacity.000 worth of products annually. The accelerator principle often assumes that the ratio of capital to output is retained at a constant level. it can be said that the companies desire to achieve constant capitalto-output ratio. In a very simple form the accelerator principle assumes that the ratio of capital to output tends to remain constant. However. Looking at another example.
sales. þÿ . the existing stock of capital goods. The accelerator effect fits the behavior of an economy best when either the economy is moving away from full employment or when it is already below that level of production. use of capacity and expectations. This is because high levels of aggregate demand hit against the limits set by the existing labor force.The accelerator effect also goes the other way: falling GNP (a recession) hurts business profits. the availability of natural resources. cash flow. worsening a recession by the multiplier effect. This in turn discourages fixed investment. and the technical ability of an economy to convert inputs into products.
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