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.

Stock-A collection of goods held by an individual or entrepreneur  Share-A part of the ownership of a company entrepreneur held by an individual or 

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. .


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.


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 ³By 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.

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 20092010. 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.

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



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.

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

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, ³it 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.


Relation between MEC and ROI 
If MEC > ROI= There will be a tendency to borrow funds in order to invest in new capital .

I in order to invest in new capital  If MEC < ROI= No firm will borrow funds 
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


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.



The concept was first developed by R.F. Khan in his famous article ³The 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

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

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 income 16

Leakages of Multiplier 
Saving Debt Cancellation Import Price Inflation Hoarding Purchase of Old Share and Securities Taxation Undistributed Profits

Criticisms of Multiplier 
Neglect of Time lags Assumption of consumption function Acceleration effect Ignored Saving is not Hoarding


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.

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 


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

Period 1 2 3 4 . . & so on Total Change in Investment 100 . . . 100 Change in Income 100 50 25 12.5 . . . 200 Change in Change in Consumption Saving 50 25 12.5 6.25 . . . 100 50 25 12.5 6.25 . . . 100

Limit of multiplier 1 to ’ Forward Operation Backward Operation Static Version Dynamic Version


Acceleration Principle The principle of Acceleration was first introduced by J.M. clark. A
demand for consumption goods leads to an increase (decrease) in investment on capital goods 

This principle explains the process by which an increase (decrease) in 

According to Prof. Kurihara ³ The accelerator coefficient is the ratio between induced investment and initial change in consumption expenditure.  Symbolically = ¨I\ ¨C««««««««««.(1) {Samuelson View}  ¨I= ¨C«««««««.(2) is the Accelerator coefficient, ¨I is net change in investment 


& ¨C is the net change in consumption expenditure.

Acceleration Principle If the increase in consumption expenditure of Rs 10 crores leads to an A the accelerator coefficient is 3 increase in investment of Rs 30 crore,
in the demand for output. 

In an economy , the required stock of capital depends on the change 

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.

Acceleration Principle This equally applies to an economy where if the value of the A capital is required per unit of out accelerator is greater than one, more
put . (depreciation and obsolescence)plus net investment. 

Gross investment in the economy will equal replacement 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.

Acceleration Principle That is why this theory more broadly interpreted by Hicks as the ratio A 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= (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


Operation of the theory
Period 1 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 Total Output 2 100 100 105 115 130 140 145 140 130 125 Required Cap. 3 400 400 420 460 520 560 580 560 520 600 Repl. Inv. 4 40 40 40 40 40 40 40 40 40 40 Net. Inv. 5 0 0 20 40 60 40 20 -20 -40 -20 = Gross Inv. 6 40 40 60 80 100 80 60 20 0 20

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






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