Investment

Investment Demand
• Types of investment
• Business fixed investment
• Residential investment
• Inventory investment
• Determinants of Inventory Investment
• The inventories of raw materials and goods depend
on the level of output which a firm plans to produce.
• N= BY
• In = ∆N = β∆Y
• According to accelerator model, firms hold the stock of inventories of raw materials and
goods in proportion to level of output.
• N = Stock of inventories
• Y = level of output
• β = Proportion of output (Y) that the firms want to hold as inventories
• The accelerator model predicts that given the parameter β when output of firms
increases, inventory investment will increase and when output falls, the inventory
investment by firms will decline.
• Autonomous investment – investment does not change with changes in income.
• Keynes- Investment depends upon marginal efficiency of capital and the rate of interest.
• Autonomous investment- ex: houses, public undertakings and other types of economic
infrastructure such as power, transport and communication.
• Autonomous investment depends more on population growth and technical progress than
on the level of income.
• This is a horizontal straight line.
 Induced Investment

• Induced investment is that investment which is affected by

the changes in the level of income.
• Greater the level of income, the larger the consumption of the
community.
• To produce more of consumer goods, more investment has to
be made in capital goods so that greater output of consumer
goods becomes possible.
• The essence of induced investment is that greater income and
therefore greater the aggregate demand affects the level of
investment in the economy.
• The induced investment underlines the concept of the
principle of accelerator, which is highly useful in explaining
the occurrence of trade cycles.
• According to Keynes investment decisions are taken
by comparing the marginal efficiency of capital
(MEC) or the yield with the real rate of interest (r).
• So long as the MEC is greater than r, new investment
in plant, equipment and machinery will take place.
• As more and more capital is used in the production
process, the MEC will fall due to diminishing
marginal product of capital.
• As soon as MEC is equated to r, no new investment
will be made in any income-earning asset.
 Marginal efficiency of capital

• MEC is equal to that rate of discount which

would make the present value of the series of
annuities given by the returns expected from
the capital asset during its lifetime just equal
to its supply price.
• According to Keynes, MEC is the rate of
discount which renders the prospective yields
from a capital asset over its whole life period
equal to the supply price of that asset.
• Determinants of Private Investment:
• 1. Prospective income from the capital asset;
• 2. Supply price of the capital asset; and
• 3. The rate of interest.
• Prospective Income: it is defined as expected revenues
from the use of the capital asset minus variable cost.
• Supply Price: it refers to the cost of the asset. Suppose
the machine costs SR 3000. This will be known as the
supply price of the asset. Supply price is the current
cost of the asset.
• Prospective yield: it is the future return on the asset
• Ex:
• Suppose the cost of machinery is Rs 3000
• Life of machinery is 2 yrs
• Suppose the machinery is expected to yield income of Rs 1100 in first yr
and Rs2420 in the 2nd yr.
• Then calculate the value of r that is MEC
• Supply price = Discounted prospective yields
• C = R1/1+r) + R2/(1+r)2
• 3000 = 1100/(1+r) + 2420/(1+r)2
• On calculating the value of r it is found equal to 10. Therefore, MEC is 10%
• Substitute this in the formula, we get Rs3000
 Determinants of Investment

• Investment demand depends upon two factors:

• 1. expected rate of profits to which keynes gives the name
Marginal Efficiency of capital.
• 2. the rate of interest.
• Rate of interest: If the expected rate of profit is greater
than the market rate of interest, new investment will take
place.
• Investment depends upon marginal efficiency of capital on
one hand and the rate of interest on the other.
• Investment will be undertaken in any given form of capital
asset till the expected rate of profit or marginal efficiency
of capital is equal to the current rate of interest.
• Example: if you are given an option to accept SP
100 now or SP 100 five years hence, you will
definitely like to have SP 100 now rather than five
years afterwards. If you are to be asked to wait for
five years, you will demand more than SR 100.
• Similarly, every person will evaluate SP 100 in
present more than SP 100 in future. The present
value of SP 100 in future will be less.
• For t years, at a rate of interest of r per cent, the
present value is calculated by this formula:
• P = 𝐴 / (1+𝑟)𝑡
 Marginal Efficiency of capital
• Supply Price = Discounted Prospective Yields
• C0 = R1 + R2 + R3 ……+ Rn
• (1 + e) (1 + e)2 (1 + e)3 (1 +e)n
• C0 stands for supply price or replacement cost
• R1, R2, R3….Rn etc., represent the annual prospective yields from the
capital asset, e is that rate of discount which renders the annual
prospective yields equal to the supply price of the capital asset,

• e is that rate of discount which renders the annual prospective yields equal
to the supply price of the capital asset.

• Thus, e represents the expected rate of profit or marginal efficiency of

capital.
• Marginal Efficiency of Capital (MEC): The rate of discount (e) which
equalizes the present value of the prospective yield of an asset with its
supply price is known as marginal efficiency of capital (MEC).
• With increase in investment, MEC falls. This is due to the
following reasons:
• 1. The marginal revenue productivity of capital falls as more
and more capital is employed;
• 2. The supply price of capital assets increases when more of
them are demanded.
• 3. The increased output of the goods being produced with the
help of capital will tend to drive down their prices.
• Therefore, at higher rate of interest, less capital investment will take
place. More private investment will take place at a lower rate of interest.
• Rate of Interest: It refers to the cost of funds required to finance the
project.
• Criteria for Investment: Investors take decision on comparing MEC to
rate of interest:
• 1. If the MEC > the rate of interest, the investors will be inclined to carry
out investment;
• 2. If the MEC < the rate of interest, the investors will not be inclined to
carry out
• investment; and
• 3. If the MEC = the rate of interest, the investors will be neutral to carry
out investment;
Marginal efficiency of capital
 Rate of Interest and Investment Demand Curve

• The equilibrium level of investment will be

established at the point where marginal efficiency of
capital becomes equal to the given current rate of
interest.
• Marginal efficiency of capital in general shows the
demand for investment or inducement to invest at
various rates of interest. Hence MEC curve represents
the investment demand curve.
• This investment demand curve shows how much
investment will be undertaken by the entrepreneurs
at various rates of interest.
 Planned Investment Schedule

• Planned investment spending is a negative function of the

interest rate. An increase in the interest rate from 3 percent to
6 percent reduces planned investment from I0 to I1.
•  
 Example
• Suppose you have an opportunity to purchase an asset which costs Rs.
1,000. It is expected to yield Rs. 585 at the end of the first year and Rs. 585
at the end of the second year (and zero thereafter). If the market rate of
interest is 10%, is it to your advantage to purchase the asset? Explain your
answer.
 Profit Expectations and Shift in Investment
• Rate of investment depends on the rate of interest. If it is interest-
elastic, a low rate of interest tends to stimulate investment.
• Factors causing shift in Investment Demand Curve
• 1. Business Expectations and animal spirits- a. Profit expectations and b.
swings of optimism and pessimism of the business class are important
driving forces in the stock market that determine investment.
• 2. Increase in growth rate of economy
• 3. Increase in capital stock
• 4. Technology and Innovations
• 5. User cost of capital- lower r, lower corporate income taxes, higher
investment tax credit.
• 4. Availability of credit.- borrowings from banks, raising resources
through issue of equity capital (selling shares in the stock market),
internal savings of the firms (retained earnings of the firm)
• 5. Fiscal Policy
 Planned Aggregate Expenditure and the Interest Rate

• An increase in the interest rate from 3 percent to 6 percent lowers planned

aggregate expenditure and thus reduces equilibrium income from Y0 to
Y1.
 Accelerator
• The multiplier describes the relationship between investment and income,
i.e., the effect of investment on income.
• The multiplier concept is concerned with original investment as a stimulus
to consumption and thereby to income and employment. But in this
concept, we are not concerned about the effect of income on investment.
This effect is covered by the ‘accelerator’.

• The term ‘accelerator’ is associated with the name of J.M. Clark in the
year 1914. It has been proved a powerful tool of economic analysis since
then.
• According to the principle of accelerator, when income increases, people’s
spending power increases; their consumption increases and consequently
the demand for consumer goods increases. In order to meet this enhanced
demand, investment must increase to raise the productive capacity of the
community.
 Acceleration Effect
0 1 2 3 4 5 6

Quantity 1000 1000 2000 3000 3500 3500 3400

demanded by
consumers
(sales

Number of 10 10 20 30 35 35 34
machines
required

Induced 0 10 10 5 0 0
investment (I
i ) (extra
machines)
Replacement 1 1 1 1 1 0
investment (I
r)
Total investment 1 11 11 6 1 0
(I
i+I
r