Investment

Investment

• Definition:
When a person buys shares, bonds or debentures of a public
ltd. Company from the market , it is generally said that he has
made investment. But this is not the real investment which
determines income and employment in the country. Buying of
existing shares and bonds by an individual is merely a financial
investment.
By real investment we mean the addition to the stock of
physical capital; such as plant, machines, trucks, new
factories, buildings, equipment tools and so on that creates
income and employment.
 Gross Vs Net Investment

• Gross Investment: The total purchase of new capital goods

during a year is called gross investment.
• Net Investment: Gross investment less replacement or
depreciation is called net investment.
 Types of Investment

1. Business fixed investment:

It means investment in the machines, tools and equipments
that businessman buy for used in further production of
goods and services. The stock of these machines or plant
equipment etc. represents fixed capital.
2. Residential investment:
It refers to the expenditure which people make on
constructing or buying new house or dwelling apartments for
the purpose of living or renting out to others.
 Types of Investment

3. Inventory investment:
Firms hold inventories of raw materials, semi-finished goods
to be processed into final goods. The firms also hold
inventories of finished goods to be sold shortly. The change
in the inventories or stock of these goods with the firms is
called inventory investment.
 Components of Investment

1. Plants and machinery;

2. Construction; and
3. Stocks.
 Private Vs Public Investment

• Private investment: it refers to the expenditure incurred by

the private entrepreneurs on the purchase of capital goods
like plant and machinery, or construction of houses, factories,
offices, shops, etc.
• Public investment: investment expenditure by the
government.
 Motivations for investment

• Expected profitability is the main motive for investment in

private sector of the economy. In public sector, these
decisions are motivated by profitability in terms of surplus of
social benefits over social costs.
 Autonomous Vs Induced Investment

• In the private sector, investment may be of two types:

• Autonomous investment:
It refers to the investment which does not change with the
changes in the income level. Autonomous investment
generally takes place in house, roads, public undertakings and
in other types of economic infrastructure such as power,
transport and communication.
• Induced Investment:
It is that investment which is affected by the changes in the
level of income. In order to produce more consumer goods,
more investment has to be made in capital goods greater
output of consumer goods becomes possible.
 Determinants of Private Investment

• 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 $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. 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
 Factors that can affect investment schedule

1. The cost of capital. If capital is cheaper, then investment

becomes more attractive. For example, the development of
steel rails made railways cheaper and encouraged more
investment.
2. Technological change. If there is an improvement in
technology, it can make investment more worthwhile.
3. Expectations and business confidence. If people are
optimistic about the future, they will be willing to invest
because they expect higher profits. In a recession, people may
become very pessimistic, so even lower interest rates don’t
encourage investment. (e.g. during recession 2008-12,
interest rates were zero, but investment low)
 Factors that can affect investment schedule

4. Supply of finance. If banks are more willing to lend money

investment will be easier.
5. Demand for goods. Higher demand will increase the
profitability of capital investment.
6. The rate of Taxes. Higher taxes will discourage investment.
Sometimes, governments offer tax breaks to encourage
investment.
 Marginal Efficiency of Capital (MEC)

• The rate of profit expected from an extra unit of capital asset is

known as marginal efficiency of capital. The rate of discount (r)
which equalizes the present value of the prospective yield of an
asset with its supply price is known as marginal efficiency of
capital (MEC).
• For calculation of Marginal Efficiency of Capital (MEC), the
formula will be:
Cr = 𝑅1/(1+𝑟)1 + 𝑅2/ (1+𝑟)2 + 𝑅3/(1+𝑟)3 + 𝑅4/(1+𝑟)4 … … . + 𝑅t/(1+𝑟)t
• Where, Cr = replacement cost or supply price of an asset; R1,
R2, R3…. Rt are the prospective annual yields for the periods, 1,
2, 3,…., t respectively and r is the rate of discount.
 Criteria for Investment

• 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 (MEC)
• Example: The supply price of a machine is $110 and its life is two
years. In each year of its life it yields $72. Calculate its marginal
efficiency of capital (MEC).
• Solution: the marginal efficiency of capital can be found by equating
the supply price ($110) and present value of expected yields ($72 in
each year) with the help of this formula:
Cr = 𝑅1/(1+𝑟)1 + 𝑅2/(1+𝑟)2
110 = 72/(1+𝑟)1 + 72/(1+𝑟)2
110(1+r)2 = 72 + 72 + 72r
110(1+2r+ r2) = 144 + 72r
110 + 220r + 110r2 = 144 + 72r
110r2 + 148r – 34 = 0
Which gives, r = 0.2 = 20%
 Marginal Efficiency of Capital (MEC)
• Given the value of r as 20%, we can calculate the prospective
yield per annum as follow:
I year: $𝑅1/(1+𝑟)1 = 72/ (1+0.20)1 = 72/1.20 = $60
II year: $𝑅2/(1+𝑟)t = 72/(1+0.20)2 = 72/(1.2)2 = $50
• The rate of discount is 20%. The sum of discounted value of
prospective annual yield ($60 + $50 = $110) equals the supply
price of capital asset ($110). Investment in the asset is
profitable if the cost of borrowing is less than 20%. In other
words, if the rate of discount (MEC) exceeds the rate of interest
(r), it will be desirable to invest.
 Keynes’s Theory of Investment

• According to Keynes investment depends upon MEC and the

rate of interest in the short-run. But in the long-run changes in
income level affects investment only.
• A person having an amount of saving has two alternatives
before him. Either he should invest his saving in machines,
factories etc. or he can lend his savings to others on a certain
rate of interest.
• If investment undertaken in machine or factories is expected
to fetch 25% rate of profit, while the current rate of interest is
only 15%, it is obvious that the person would invest his
savings in machinery or factory.
 Keynes’s Theory of Investment

• If the expected rate of profit is greater than the market rate of

interest, new investment will take place.
• If an entrepreneur does not invest his own saving but has to
borrow from others, the expected rate of profit from
investment in any capital asset must not be less than the rate
of interest he has to pay.
 Keynes’s Theory of Investment

• Why are interest rates important for determining the

marginal efficiency of capital?
To finance investment, firms will either borrow or reduce
savings. If interest rates are lower, it’s cheaper to borrow, or
their savings give a lower return making investment relatively
more attractive.
A cut in interest rates from 5% to 2% will increase investment
from 80 to 100.
The alternative to investing is saving money in a bank; this is
the opportunity cost of investment.
If the rate of interest is 5%, then only projects with a rate of
return of greater than 5% will be profitable.
Keynes’s Theory of Investment
 Keynes’s Theory of Investment

• How responsive is Investment to Interest Rates?

In Keynesian investment theory, interest rates are one
important factor. However, in a Liquidity trap, investment may
be unresponsive to lower interest rates. In some
circumstances, demand for investment is very interest
inelastic.
In a liquidity trap, business confidence may be very low.
Therefore, despite low-interest rates, firms don’t want to
invest because they have low expectations of future profits.
Keynes’s Theory of Investment
 Investment Multiplier
• It shows the relationship between change in investment and
the resulting change in income.
• An increase in investment in an economy leads to an increase
in income which is more than the proportionate increase in
investment.
• The multiplier coefficient (K) measures the change in income
due to change in investment. In other words,
K = Δ𝑌/Δ𝐼 = 1/(1−𝑀𝑃𝐶) = 1/𝑀𝑃𝑆
• Higher the value of MPC, higher will be the value of multiplier.
• Higher the value of MPS, lower will be the value of multiplier.
 Investment Multiplier
• Ex-1: What will be the value of multiplier if the marginal
propensity to save is 0.4?
• Solution: Multiplier, K = 1/MPS = 1/0.4 = 2.5
• Ex-2: Given MPC = 0.6, calculate the value of Δ𝑌, Δ𝐶 𝑎𝑛𝑑 Δ𝑆
when investment increases by $2000 million.
Δ𝑌 = Δ𝐼/(1 –MPC) = 2000/1−0.6 = 5000
Δ𝐶 = Δ𝑌 × 𝑀𝑃𝐶 = 5000 × 0.6 = 3000
Δ𝑆 = Δ𝑌 × 𝑀𝑃𝑆 = ΔY(1 − 𝑀𝑃𝐶) = 5000 (1 − 0.6) = 5000 × 0.4 =
2000
 Investment Multiplier
• Ex-3: If the Bangladesh economy plans to generate $1000
million of additional income, how much additional investment
will be required if MPS = (i) 0.5, (ii) 0.4?
• Ex-4: If the Bangladesh economy plans to generate $200
million of additional income, how much additional investment
will be required if MPC = (i) 0.3, (ii) 0.4?
• Ex-5: Find the value of MPC and MPS if an additional
investment of $100 million generated an additional income of
$500 million.
 Accelerator Theory of Investment
• The Keynesian concept of multiplier states that as the
investment increases, income increases by a multiple amount.
• The net induced investment will be positive if national income
increases and induced investment may fall to zero if the
national income or output remains constant. To produce a
given amount of output, it requires a certain amount of
capital. If Yt output is required to be produced and v is capital-
output ratio, the required amount of capital to produce
Yt output will be given by the following equation:
Kt = vYt …(i)
where ,
K stands for the stock of capital,
Yt for the level of output or income, and
v for capital-output ratio
 Accelerator Theory of Investment
• This capital-output ratio v is equal to K/Y and in the theory of
accelerator this capital-output ratio is assumed to be
constant. Therefore, under the assumption of constant
capital-output ratio, changes in output are made possible by
changes in the stock of capital. Thus, when income is Yt then
required stock of capital Kt = vYt. When output or income is
equal to Yt-1, then required stock of capital will be Kt-1 = vYt-1.
• It is clear from above that when income increases from Yt-1 in
period t – 1 to Yt in period, t, then the stock of capital will
increase Kt-1 from to Kt. As seen above, Kt-1 is equal to vYt-1 and
Kt is equal to vYt.
 Accelerator Theory of Investment
• Hence, the increase in the stock of capital in period t is given by the
following equation:
Kt-Kt-1 = vYt – vYt-1
Kt-Kt-1 = v (Yt – Yt-1) …(ii)
Since increase in the stock of capital in a year (Kt – Kt-1) represents
investment in that year, the above equation (ii) can be written as
below:
I1 = V (yt – yt-1) …(iii)
Equation (iii) reveals that as a result of increase in income in any
year t from a previous year t- 1, increase in investment will be v
times more than the increase in income. Hence, it is v, i.e., capital-
output ratio, which represents the magnitude of the accelerator. If
the capital-output ratio is equal to 3, then as a result of a certain
increase in income, investment will increase three times more, i.e.,
accelerator here will be equal to 3.
 Accelerator Theory of Investment
• It thus follows that investment is a function of change in
income.
i) If income or output increases over time, that is, when Yt is
greater than Ft-1 then investment will be positive.
ii) If income declines, that is, Yt is less than Yt-1 then
disinvestment will take place. And
iii) If the income remains constant, that is, Yt = Yt-1 the
investment will be equal to zero.
 Accelerator Theory of Investment (Criticism)
• The principle of acceleration has come in for a good deal of
criticism in recent years. For example, it has been pointed out
by Kaldor that we cannot assume a constant value of the
accelerator throughout the trade cycle, that is, it is not true
that an increase in output or income by an amount must
always give rise to a multiple increase in investment.
• This is because, if already, some machines are lying idle, we
shall try to use them before rushing in for new equipment.
Also, if expectation of entrepreneurs is that the rise in
demand brought about by increase in income or output is
only a temporary one, they will try to meet it by overworking
the existing machinery rather than installing a new plant.
Thus, in the theory of accelerator it has been assumed that
there is no excess capacity existing in consumer goods
industries
 Accelerator Theory of Investment (Criticism)
• In other words, it has been assumed that no machines are
lying idle and no extra shift working is possible. If there had
been excess capacity and extra shift working was possible, the
supply of goods could be increased with the existing
equipment and the accelerator would not come into play.
• Further, in the acceleration principle it has also been assumed
that in the capital goods industries, there exists surplus
productive capacity. If there is no excess capacity in the
machine-making industries, increased demand for machines
caused by the requirement for additional output would not
lead to increase in the supply of machines.
 Accelerator Theory of Investment (Criticism)
• In the absence of supply of machines, investment cannot increase
in the short run. It is thus assumed in the accelerator theory that
the machine-making industry is capable of increasing its output for
the time being at least. The supply can be increased by reducing
stocks of finished machines, by working extra shifts, and so on. But
stocks cannot be reduced below zero and working double shifts or
adoption of other experiments is found to be expensive. Only when
the demand has increased permanently, will the entrepreneurs find
it worthwhile to increase investment in machine-making industries.
• The size of the accelerator does not remain constant over time. Its
value will be affected by the businessmen’s calculation regarding
the profitability of installing new plants to make more machines on
the basis of their probable working life. It is also assumed that the
demand for machines will remain stable in future, although the
increase in demand has suddenly cropped up.
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