Economics Unit 2

Handout

INVESTMENT

This include the spending by businesses or individuals on items such as machines and buildings,
which can be used to produce goods and services in the future. The investment part of total
income is that portion which will be used in the process of producing goods in the future.
Sometimes the term is used simply to mean any spending which generates future income.

There are two important elements of investment. These are:

● The purchase of new capital, such as equipment and factories
● An increase in stock levels

Gross and Net Investment

Gross investment is the total level of investment that occurred within the period.
Net Investment represents the increase in the capital stock. It is important to note that some
investment is simply to replace capital which has worn out overtime i.e. depreciated. Net
investment is therefore calculated as:
Net Investment = Gross Investment – Depreciation

Planned investment vs Actual investment

Planned Investment is the amount of investment that firms, individuals or public bodies intend to
make during a specific period of time.

Actual investment is the amount of investment expenditures that the business actually undertakes
during a given period of time. This is includes both planned investment and any unplanned
inventory changes.

Investment is a critical component of Keynesian economics and the analysis of macroeconomic

equilibrium which can only occur when actual investment is equal to planned investment.
Therefore the difference between planned and actual investment is unplanned investment.

Actual investment may not correspond to planned investment for various reasons. Fixed
investment plans may be frustrated because the investment goods required cannot be obtained, as
likely in booms, or because the arrangements for financing the expenditure collapse, as is likely
during a slump. Investment in stocks may fall short of planned levels because of unforeseen
increases in demand or may exceed planned levels because goods cannot be sold, so that stocks
accumulate until production can be cut back.

Autonomous and Induced Investment

Autonomous investment is investment that occurs without changes in the level of national
income. In other words, it is unrelated to the level of national income. Conversely Induced

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investment is investment which is related to changes in the level of national income. This is
related to the accelerator principle that will be discussed later.

The Investment Schedule

Planned investment and the rate of interest are inversely related, that is, as interest rate (r)
increases, Investment decreases. Conversely, as the interest rate falls, investment spending
increases. Therefore interest rate will cause movement along the investment schedule. The
figure below shows the investment schedule.

Rate of
interest

Id = MEC

Planned investment

Since interest rate is seen as the cost to borrow money, the higher the rate of interest, the more
expensive it will be for businesses to finance investment. Hence investment will become less
profitable, thus people and businesses will invest less. It is therefore safe to say that investment
demand/(MEC) is a function of expected rate of return. Marginal efficiency of capital will be
dwelt with later

Other Determinants of Investment

These are factors, other than interest rates, that have major influence on investment. They will
bring about a downward or upward shift of the investment schedule. These factors include:

● Expectations – firms estimate the future demand for their products in order to assess the
likely future profitability of their investments. If higher future sales are expected, then more
machines and bigger plants will be planned for the future. More investment will be
undertaken.
In addition, exclusive and difficult-to-predict factors such as changes in the domestic
political climate, the thrust of foreign affairs, population growth and stock market condition
must be taken into account on a subjective or intuitive basis. If business executives are more
optimistic about future business conditions, the investment curve will shift to the right while
a pessimistic outlook will shift the investment curve to the left.

● Cost of new capital goods – if the cost of new plant, machinery and equipment suddenly
increased (relative to the price at which output could be sold), firms’ investment plans may
change causing the investment curve to shift leftward. The opposite will occur if there was
an abrupt, unanticipated fall in the relative cost of capital goods. It is important to note that

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 investment goods become relatively cheaper, even if prices remain the same, if labour costs
rise. Labour-saving investment may then increase.

● Innovation and technology – both improvements in current productive technology and

innovations could generally be expected to shift the investment curve to the right, since both
would stimulate a demand for additional capital goods. In other words, we would see an
increase in the demand for capital goods at any interest rate.

● Taxes on profits – Firms estimate rates of return on investments on the basis of expected
after-tax profits. If there is an increase in tax rates on profits, ceteris paribus, we expect a
leftward shift in the planned investment curve. If there is a decrease in tax rates, there will be
a rightward shift in the investment curve.

The Acceleration Principle

The principle of the accelerator states that the level of investment varies with changes in
the level of output. Otherwise stated, the level of investment depends on the rate of change of
national income. The term accelerator is used because a relatively modest rise in national
income can cause a much larger percentage rise in investment. The accelerator principle show
that it is the rate of growth or income and output rather than the fact that output is growing, that
determines whether investment is growing, falling or at a constant level. According to the
principle:
● If income is growing by a constant amount each year, net investment is also constant
● If the rate of growth of income speeds up or accelerates, net investment increases
● If the rate of growth of income slows down or decelerates, net investment declines

The accelerator principle in its simplest form states that net investment (I) is determined
by the change in income multiplied by a fixed quantity – the accelerator coefficient ( v ) – which
is the amount of investment necessary to produce an extra unit of output. That is, I = v( Y) or
I = v(Y2 – Y1). For example, if a machine cost $20,000 and produces annually $10,000 worth of
output the coefficient will be:
20,000 = 2 (meaning that it will take $2 worth of I to produce $1 extra unit of output)
10,000
Let’s see how it works:
Assume that income is constant and that the existing capital stock (the value of the machines,
equipment and buildings) is working at full capacity. If income start to rise demand will increase
putting pressure on manufacturers to expand their capacity in order to meet that demand. The
resulting new net investment will be a multiple of the change in income because in the example
above it takes $2 of investment to produce $1 of extra output. The process will continue as long
as income rises at the same rate or faster. However, it the rate of growth of income decline then
the net investment will fall. See Table 1 below:

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Year Y ∆Y Net I
0 1000 0 0
1 1100 100 200
2 1210 110 220
3 1282 72 144
4 1333 51 102
5 1360 27 54
6 1360 0 0
We assume an accelerator coefficient $2

Factors affecting the volatility of investment

Unlike the consumption schedule, the investment schedule is very unstable and shifts
significantly upward and downward quite often. Proportionately, investment is the most volatile
(unstable) component of total spending (expenditure). The factors explaining the variability of
investment are outlined below:

● Durability – because of their durability, capital goods have an indefinite useful life. The
purchase of capital goods can be seen as discretionary and therefore can be postponed. Older
equipment or buildings can be scrapped and entirely replaced or patched up and used for a
few more years. Optimism about the future may prompt business planners to replace their
older facilities; modernizing their plant will call for high level of investment. A less
optimistic view, may lead to very small amounts of investment as older facilities are repaired
and kept in use.

● Irregularity of Innovation – Technological progress is a major determinant of investment.

New products and processes provide a stimulus to investment. However, major innovations
such as railroads, electricity, motor vehicle, fibre optics and computers occur quite
irregularly and when they do occur they result in large spending on investment.

● Variability of profits – businesses will only invest when it is profitable and there is an
expectation of future profits. Current profits can be variable and so working as a deterrent
for investors. Thus, the variability of profits contributes to the volatile nature of the incentive
to invest. Expanding profits give business planners both greater incentives and greater means
to invest; declining profits have the reverse effects. The fact that actual profits are variable
adds to the instability of investment.

● Variability of expectations – while businesses often forecast sales or profit into the future,
there are certain factors that can cause significant changes in future business conditions.
Changes in the domestic political climate, changes in exchange rates, changes in population
growth and therefore in anticipated demand, legal issues, changes in trade barriers and
changes in government economic policies may cause substantial shifts in the business
optimism and pessimism. Which will impact the investors’ decision to invest or not.

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Limitations of the Accelerator Theory

1. The accelerator is too mechanical. It assumes that all firms react to increased demand for
their output in the same way. Some firms may wait to see if the higher level of demand is
maintained, whilst others may order more plant and machinery than is immediately
required
2. The accelerator principle assumes that there is no spare capacity or unused capital. If
when demand for their output increases, firms already possess excess capacity left over
from a previous boom in demand, the firms could increase output by utilizing this spare
capacity, without the need to invest in additional fixed capital
3. Demand may increase at a time when the capital goods industries are themselves at full
capacity and are unable to meet higher level of investment demand. In this situation, the
price of capital goods is likely to rise, and reinforced by the unavailability of capital
goods, and switch to more labour-intensive methods of production. The capital output
ratio will fall, with the result that firms can increase output to meet the new levels of
demand without necessarily investing in much more capital
4. Firms often have stocks, so if output increases they can meet this without having to
produce more
5. With changes in technology, the accelerator coefficient may change, and firms may not
deed to invest as much as before

Investment Demand Curve vs Investment Curve

Investment demand curve shows the relationship between the real interest rate and the level of
investment spending. The relationship is an inverse one. the lower the interest rate the greater
the investment spending. This means that the investment demand curve is downward sloping

Investment Curve
The investment decision of individual firms can be aggregated to construct an investment
schedule or curve. It shows the amount of business firms collectively intend to invest at each
possible level of GDP