THE

INVESTMEN
T FUNCTION
INVESTMENT:
A
DETERMINAN
T OF INCOME
BASIC CONCEPT OF
INVESTMENT
Investment Expenditure – It is a capital spending
mainly derived not from current income and
consumption but from accumulated savings and
other sources external to the circular flow.
It should be noted that investment spending,
which is for long-term consumption, is not the
monopoly of business since households and
government do as well.
INVESTMENT AND
THE MULTIPLIER
The following equations illustrate how the investment
factor is incorporated in the income function with the
multiplier process:
Where:
y = Income
C = Consumption
I = Investment
Since initially: M = Multiplier
= Change
y=C
Therefore:
y=C+ +I The equations further imply that
investment is directly
y=C+I proportional to income.
INVESTMENT
AND
OUTPUT
BASIC CONCEPTS
Business and household investments tend to increase the
economy’s stock of capital and total output; whereas,
depreciation has the opposite effect as it represents capital
consumption. While current depreciation decreases total output in
the short-run, current investment only yields output in the long-
run for two reasons.
1. Even after total investment expenditure to meet production
targets has already been incurred, the process of setting up
and even testing the capital base creates operational lags.
2. Every phase in setting up a capital base may not be capable
of independent utilization until the completion of the other
phases.
INVESTMENT AND
THE STOCK
ADJUSTMENT
PROCESS
Despite the investment-production time lag, sustained
investment patterns can determine trends in the capital
stock and production level over a long period.
The following framework illustrates investment-output
relationship assuming a short-run time frame, no
investment-production time lag, and constant capital output
ratio.

=(
- + ) = a( - D + I)
INVESTMENT AND
THE STOCK
ADJUSTMENT
PROCESS
Where:
= Stock of capital after depreciation and investment
= Initial stock of capital, i.e., before depreciation and investment
D = Depreciation
I = Investment
= Initial output from the capital stock, i.e., before depreciation and
investment
= Total output from the capital stock after depreciation and investment
= Change in total output because of depreciation
= Change in total output because of investment
a = Output-capital ration (Y/K)
INVESTMENT AND
THE STOCK
ADJUSTMENT
PROCESS
Furthermore:

 Net change in capital stock

= (-D + I)

 Net change in output

= (- + )
SAVINGS AS A
SOURCE OF
INVESTMENT
SAVINGS CONCEPTS
Savings – It is the unspent portion of income
during the period intended for spending.
Savings of the economy can be simply
expressed as follows assuming that it is the only
determinant of the multiplier.
S=Y–C
Where:
S = Savings
Y = Income
C = Consumption
SAVINGS-
INVESTMENT
EQUILIBRIUM
Going back to the new income equation,
Y=C+I
Y–C=I
S=I
Assuming that income is now fully generated, (S = I)
means completing the process of transforming the
investment inflow into savings outflow which gradually
reduces the additional income that the system generates. In
essence, what goes in will then come out of the circular
flow in the forms of savings, taxes, and imports.
DETERMINANTS OF
SAVINGS
Price Level Population Growth
INVESTMENT
DEMAND
DETERMINAN
TS
 Interest Rate
Investment demand is
inversely proportional to
the interest rate level with
other factors as constant
(ceteris paribus) resulting
in an investment demand
curve that is downward
sloping.
The Acceleration Principle
The principle states
that the level of
investments is a function of
desired changes in output.
This change in investment
constitutes a shift in the
investment demand curve.
 Innovations

 It can create demand for products

including capital goods and usher
the acceleration process between
income and investment.

Joseph Schumpeter
 A noted development economist in
contemporary times.
 Describes innovation as the
introduction of an unfamiliar
product and untested technology,
opening a country’s product to
markets and sources of raw
material not previously
encountered and the setting up of a
new organization in any industry.
 Profit Expectations

 It is the basic reason why a  A businessman invests and

business invests and, therefore, expects a certain level of profit
it trends influence business given a certain influence of the
investments in the long-run. business environment.
INVESTMENT
DEMAND-SUPPLY AND
FOREIGN
BORROWINGS
Local supply-demand constraints may
induce the economy to tap external sources
of funds which traditionally was the case in
the Philippines because of the unrealistic
interest rate ceilings pegged by the
government in the 70’s and 80’s.
INVESTMENT
AND THE
BUSINESS
CYCLE
BUSINESS CYCLE
CONCEPTS
BUSINESS CYCLE
CONCEPTS
Recovery
Increase in Real GNP.
Increases in employment, income, production, capacity
utilization, and price.
Boom – The peak of recoveries upturn.
Recession – follows recovery with reverse trends
in employment, income, production, capacity
utilization, and price.
Depression – It is when the economy reaches the
rock bottom.
DURABILITY OF
CAPITAL: A SOURCE
OF INSTABILITY
a) Price level is constant implying that variations in the desired
expenditure level indicate changes in the desired production level.
b) Ratio of expenditure to capital stock is equal to 2.
c) Price of capital is equal to 2.
d) Marginal propensity to consume is 0.50 and, therefore, the
multiplier is 2.
e) Periodic replacement in the capital stock is 5.
f) Replacement of additions to the capital stock because of
depreciation only takes effect after 4 periods.
g) No investment-output time lag.
h) A change in the level of investment expenditure only affects
income in the subsequent period.