Macroeconomics

Lecture Notes #4

TOPIC: INVESTMENT

What is Investment?

Investment is the purchasing of capital goods by businesses. It is the mechanism by which the
productive capacity of an economy is increased. It is the value of machinery, plants, and
buildings that are bought by firms for production purposes.

Capital Accumulation- this is the process of acquiring additional capitals tock for productive
purposes.

Elements of Investment

There are two elements to investment:

• GROSS FIXED CAPITAL FORMATION

This accounts for spending on new fixed assets such as machinery, factory plants and
other capital goods which enable increase in production of goods and services in future
time periods.

• INCREASES IN INVENTORIES
This is the value of increase in the volume of finished goods and unfinished goods (work-
in-progress) which firms possess. Inventories are considered as investment because it
creates value in the future.

Significance of Investment

Investment plays six macroeconomic roles:

1. it contributes to current demand of capital goods, thus it increases domestic expenditure;

2. it enlarges the production base (installed capital), increasing production capacity;
3. it modernizes production processes, improving cost effectiveness;
4. it reduces the labour needs per unit of output, thus potentially producing higher productivity
and lower employment;
5. it allows for the production of new and improved products, increasing value added in
production;
6. it incorporates international world-class innovations and quality standards, bridging the gap
with more advanced countries and helping exports and an active participation to international
trade.

HOW CAN INVESTMENT BE FUNDED?

• Self-financing in turn due to:

1. Accumulated past profits

2. Injection of new financial capital from owner

• Loans from banks and other financial institutions

1. Long term credit at fixed interest rate

2. Short term credit
3. Miro-credit for small businesses

• Capital Market finance- through the issuance of shares on stock exchange market

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 • Public funds and incentives for investment from international, national and regional
institutions.

GROSS INVESTMENT VERSUS NET INVESTMENT

GROSS INVESTMENT

This is the total level of investment at the end of a given period before depreciation is
considered. Gross investment includes:
1. Gross Fixed Capital Formation
2. Increases in inventories

NET INVESTMENT

This is the true addition to the nation’s stock of capital that can be utilized to move the
economy forward. It is obtained by subtracting depreciation from gross investment.

Net Investment = Gross Investment – Depreciation

Net Investment is positive if gross investment exceeds depreciation, i.e the purchasing of new
machines and equipment exceeds the purchasing of new parts and maintenance.

Net Investment is negative if depreciation exceeds gross investment, i.e, the purchasing of new
parts and maintenance exceeds the purchasing of new machines and equipment.
Note: At this point economic growth is stagnant as new resources are not being added to the
production process.

PLANNED INVESTMENT VERSUS ACTUAL INVESTMENT

Planned Investment are those expenditures that the business sector intends to undertake
based on expected economic conditions such as interest rates, sales and profitability. It is also
referred to as desired investment.

Actual Investment are actual expenditures undertaken by business during a given period of
time. It includes planned investment and any unplanned changes in inventories.

Why might planned investment not equal to actual investment?

Firms have control over GFCF, however there is a problem in controlling the inventory
component of investment. This component is very volatile. What is produced in an economy is
naturally sold however some of the goods produced in a given year may not be sold in that
same year but in later years.

The difference between goods produced and sold in a given year us called inventory
investment.

Inventory Investment = Production (Output) minus Sales (Expenditure)

• If firms produce more than they sell and inventories accumulate, inventory investment
is positive.
• If firms sell more than they produce and inventory falls, inventory investment is
negative.

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Actual Investment = planned investment + unplanned changes in inventories

Once there is a change in inventory, it is indicative that the economy is not at equilibrium, that
is, planned output is not equal to planned expenditure.

For planned investment to equal planned expenditure, unplanned changes in inventories must
be equal to zero. This means that the economy must be at equilibrium which is indicative that
whatever is produced is sold.

Consider the exercise below:

Aggregate Output=Y
Planned Aggregate expenditure = C + I
Equilibrium = Y = AE = C + I
C = 100 + 0.75Y

Y C Planned Planned Unplanned Equilibrium

Investment Aggregate Inventory
Expenditure
100 175 25
200 250 25
400 400 25
500 475 25
600 550 25
800 700 25
1000 850 25

a. Complete the table

b. Use the Keynesian 45˚ diagram to illustrate the equilibrium level of National Income

c. Using the equation Y = C + I, calculate the equilibrium output.

You are given the following information about Country X:

Consumption Function C = 200 + 0.8 Y

Investment Function I = 100

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Aggregate Expenditure AE = C + I

1. Determine the following: MPC and MPS

2. Using the 45˚ line diagram, plot the AE function

3. Calculate the level of national income

4. Find the multiplier

0aMARGINAL EFFICIENCY OF CAPITAL VERSUS MARGINAL EFFICIENCY OF INVESTMENT

Marginal Efficiency of Capital (MEC)

This is a measure of the productivity of an additional unit of capital employed by the firm. It
shows the relationship between interest rate and planned investment. The expected rate of
return from investment is measured by the MEC.

Investment is undertaken by the firm with the objective of maximizing profits. In order to make
investment decisions, firm must evaluate the feasibility of the investment. This is done by
comparing the expected or potential yield with the cost of capital to the firm.

If the expected rate of return of the last unit of capital employed is greater than the interest
rate (cost of borrowing), the firm will invest in that unit.

If the expected rate of return of the last unit of capital employed is less than the interest rate,
the firm will not invest in that unit.

Therefore firm maximize earning potential on investment when the MEC of the last unit
employed is equal to the interest rate.

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Why is the MEC curve downward sloping?

The MEC is downward sloping because as the firm invests more the rate of return will fall due
to diminishing returns. As outline before, decisions to invest in additional unit of capital will be
determined by comparison of the IR and the expected rate of return from the last unit of
capital.

Marginal Efficiency of Investment (MEI)

This shows the relationship between interest rate and the actual rate of investment. As interest
rate decreases firms will invest more and more.

The MEI is a flow variable and represents the actual level of investment undertaken by the firm.
This can be influenced by the IR as well as other determinants of investment.

What is the difference between the MEC and MEI?

The MEC is a stock variable that shows the relationship between the IR and the desired capital
stock or planned capital stock as it relates to the rate of returns while the MEI is a flow variable
that the shows the relationship between the IR and the actual rate of investment. If the IR is
low, firms will invest less, vice versa.

DETERMINANTS OF INVESTMENT

1. Interest rate
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2. Taxes
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3. Future expectation (Keynes referred to this as animal spirit)

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4. Technological changes
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5. Stock of capital on hand

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6. Levels of National Income

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AUTONOMOUS INVESTMENT VERSUS INDUCED INVESTMENT

Autonomous Investment

These are business investment expenditures that do not depend on the level of income in the
economy. It is that investment that the business sector undertakes regardless of the state of
the economy.

Induced Investment

This is investment that is dependent on the level of income in the economy.

Note:
Autonomous and induced investment expenditure work together in the macroeconomy;
autonomous investment will stimulate production in the economy, as production increases so
does output and furthermore income. Due to increases in the income, the multiplier effect
process starts via the MPC which will compel more people to participate in the economy which
will induce investment.

THE ACCELERATOR THEORY OF INVESTMENT

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Investment is closely correlated with consumer demand fluctuations under the condition of full
employment.

The accelerator theory shows the relationship between net investment and the rate of changes
in national income.

The accelerator model is based on the assumption of a fixed capital to output ratio has to be
maintained in an economy. It stresses that planned capital investment is demand induced, i.e,
the demand for new plants and machines come from the demand for final goods and services.

Example: It normally takes $1000 worth of equipment to manufacture $1000 worth of shoes
each year.
Capital : Output ratio
1 : 1

• Suppose that each year 10% of the equipment wears out. If there is no growth or
decline, total investment each year will be $100 all for replacement investment.
• Now suppose that the sales of shoes jump by 5%. The new desired amount of
equipment will now rise by 5%. Induced investment.

Consider the table

Assume capital to output ratio 2 : 1, i.e, $2 of capital has to be purchased to be able to increase
output by $1.

Desired level of Desired Capital level Change of output Level of net

output investment
200 400
220 440
250 500
300 600
400 800
600 1200
700 1400

1. If output increase by an increasing (accelerating) amount, firms will have to buy more
machines, Net investment will therefore rise.

2. If output increase by a constant amount each period, firm will buy the same amount of
capital. Net investment will be constant.

3. If output increases buy by less than the year before, firms will not need to buy as many
capital stock. Net investment will actually fall.

THE ACCELERATOR FORMULA

It = λ(Yt – Yt-1)

Where: It – investment in time ‘t’

Λ – the capital to output ratio
Yt – output in time ‘t’
Yt-1 – output in the year before time ‘t’

LIMITATIONS OF THE ACCELERATOR THEORY

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 1. The theory is too mechanical.
The theory assumes that all firms react to a similar manner to an expansion in demand.
In practice, this is not true as some firms are more reserved while others mat act over
zealously by ordering extra capital stock.

2. The theory presumes that firms do not have any spare capacity.
It is however possible that some firms actually be carrying spare capacity prior to any
increase in demand and so may not need to engage in any additional investment to
increase productive capacity.

3. Firms often have stock so if demand increases they do not have to produce more as they
can already meet demand.

4. Full capacity in the capital goods industry.

Even if there is an increase in demand for capital goods, the full capacity operation of
the capital goods industry may limit the ability to meet to a greater level of demand for
capital goods.

VOLATILITY OF INVESTMENT

1. The accelerator theory

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2. Durability of capital stock

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3. Irregularity of innovation
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4. Variability of profits, expectations and interest rate.

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