The Investment

Function
INVESTMENT: A
DETERMINANT OF
INCOME
A. BASIC CONCEPT OF INVESTMENT
B. INVESTMENT AND OUTPUT
C. SAVINGS AS A SOURCE OF
INVESTMENT
D. INVESTMENT DEMAND
DETERMINANTS
E. INVESTMENT DEMAND-SUPPLY AND
FOREIGN BORROWINGS
F. INVESTMENT AND BUSINESS CYCLE

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A. BASIC
CONCEPT
OF
INVESTMENT

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 A. INVESTMENT: A
DETERMINANT OF INCOME
(1) BASIC CONCEPT OF
INVESTMENT
• INVESTMENT EXPENDITURE
 Capital spending mainly derive
not from current income and
consumption but from the
accumulated savings and other
sources external to cash flow
 Investment = ↑ Capital Stock
and Expenditure
 Simply assumed as an
exogenous component of National
Income

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 A. INVESTMENT: A
DETERMINANT OF INCOME
(1) BASIC CONCEPT OF
INVESTMENT
• CONSUMPTION EXPENDITURE
 Spending on Current Consumption
or consumption of Non Durable
Goods
• INVESTMENT EXPENDITURE
 Spending on Capital Goods which
are repeatedly used and gradually
consumed over a long period as
durable goods.
 Pre-payment of long-run
consumption
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 A. INVESTMENT: A DETERMINANT OF INCOME
(2) INVESTMENT AND THE MULTIPLIER

• MPC = 0.80 • Therefore:

Multiplier =5 y = C + ∆C + I
y=C+I
• MULTIPLIER PROCESS Where:
∆y = IM y = Income M = Multiplier
∆y = I + ∆C C = Consumption ∆ = Change
I = Investment
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 A. INVESTMENT: A
DETERMINANT OF INCOME
(2) INVESTMENT AND
THE MULTIPLIER
• Investment is directly proportional
to income.
• Why does the economy, does not
seem to run out of investments to
at least maintain its level of
income?
 Because investment inflows are
infinite wherein new expenditures
continue the income-generating
functions of the previous ones.

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B. INVESTMENT
AND
OUTPUT

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 B. INVESTMENT AND
OUTPUT
(1) BASIC CONCEPTS
• BUSINESS AND HOUSEHOLD
INVESTMENT
 Tend to ↑ the Economy’s Stock
of Capital and Total Output
• DEPRECIATION
 Opposite effect as it represents
capital consumption
• CURRENT DEPRECIATION
 Tend to ↓ the Economy’s
Stock of Capital and Total Output

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 B. INVESTMENT AND
OUTPUT
(1) BASIC CONCEPTS
• 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 lag.
2. Every phase in setting up a capital base
may not be capable of independent
utilization until the completion of the other
phases.
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 B. INVESTMENT AND
OUTPUT
(2) INVESTMENT and the
STOCK ADJUSTMENT
PROCESS
• CAPITAL STOCK
 Not a headcount but rather the
aggregate production capacity of
existing capital goods in the
economy which can diminish due
to usage and depreciation.
• INVESTMENT
 ↑ the stock since additional
capital brings additional
production capacity.

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 B. INVESTMENT AND OUTPUT
(2) INVESTMENT and the STOCK ADJUSTMENT PROCESS
INVESTMENT – OUTPUT RELATIONSHIP
• Short-run Time Frame, No Yi = Initial output from the capital
Investment-Production Time Lag and stock
Constant Capital Output Ratio: Yf = Total output from the capital after
Kf = (Ki – D + I) the depreciation and investment
Yf = (Yi – ∆yd + ∆yi) = a(Ki – D + I) ∆yd = Change in total output because of
• Where: depreciation
Kf = Stock of capital after depreciation ∆yi = Change in total output because of
and investment investment
Ki = Initial stock of capital a = Output-capital ration (Y/K)
D = Depreciation • Furthermore:
I = Investment * Net change in capital stock = (-D + I)
* Net change in output = (- ∆yd + ∆yi )
 B. INVESTMENT AND
OUTPUT
(2) INVESTMENT and the
STOCK ADJUSTMENT PROCESS
• (+) Net Change in Capital Stock
 (+) Net Change in output
 ↑ Capital Stock and Output
• (-) Net Change in Capital Stock
 (-) Net Change in output
 ↓ Capital Stock and Output
• Zero (O) Net Change in Capital Stock
 constant level of both Capital Stock and
Output
 Investment adjusts the capital stock to
maintain and even ↑ production
and the level of economic activities
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C. SAVINGS
AS A
SOURCE
OF
INVESTMENT

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 C. SAVINGS AS A SOURCE
OF INVESTMENT
(1) SAVINGS CONCEPTS
• SAVINGS
 the unspent portion of income
during the period intended for
spending as in the case of a salary
earner who sets aside a portion of
his half-month pay earmarked for
the next 15 days.
 It is a residual income which
accumulates into a stock for
future use which postpones
current consumption.

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 C. SAVINGS AS A SOURCE OF INVESTMENT
(1) SAVINGS CONCEPTS
• SAVINGS OF THE ECONOMY • SIMPLE SAVINGS EQUATION
 Only serves to emphasize the
S=Y–C inverse relationship between the
level of outflow and the amount of
income generated in the circular
Where: flow.
S = Savings
Y = Income  Unnecessarily includes personal
C = Consumption taxes as they are not part of
national savings but exclude the
relevant account of business
savings
 C. SAVINGS AS A SOURCE OF
INVESTMENT
(2) SAVINGS-INVESTMENT
EQUILIBRIUM
Y=C+I
Y–C=I
S=I
• ASSUME FULLY GENERATED INCOME
 (S = I)
 Means completing the process of transforming the
investment inflow into savings outflow which gradually
reduces the addition income that the system
generates.
• CETERIS PARIBUS
 ↑, ↓ or maintain the level of investment and
expenditure will respectively ↑, ↓ or maintain the
level of income and savings 17
 C. SAVINGS AS A SOURCE
OF INVESTMENT
(3) DETERMINANTS OF
SAVINGS
1. PRICE LEVEL
• Affect expenditure and savings

2. POPUPLATION GROWTH
• Change the level of savings
depending of the well being of
the company.

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D. INVESTMENT
DEMAND
DETERMINANTS

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 D. INVESTMENT
DEMAND
DETERMINANTS
1. Interest Rate
2. The Acceleration
Principle
3. Innovations
4. Profit
5. Expectations
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 D. INVESTMENT DEMAND DETERMINANTS
(1) INTEREST RATE
• EXPLANATION:
1. Interest Rate tends to squeeze profit
as a cost and therefore, reduces the
number of investments with
favorable returns.

2. Lending one’s own money to earn

interest. A rise in the interest rate
level to create a greater margin over
business rate of returns tends to
• INVESTMENT DEMAND outweigh the long-run prospects of
 Inversely proportional to the business and therefore, discourages
interest rate level with other factors money holders from investing.
as constant (ceteris paribus) resulting
in an investment demand curve that is 3. The influence of the interest rate
downward sloping. level on the resource mix.
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 D. INVESTMENT DEMAND DETERMINANTS
(2) THE ACCELERATION RATE PRINCIPLE
• EXPLANATION:
Yf = (Yi – ∆yd + ∆yi) = a(Ki – D + I)
 The same output level desired by the
economy influences investment (I) to
adjust regain production capacity lost
(D) because of depreciation, thus
leaving the capital stock (Ki – D + I)
and and the output level (Yi – ∆yd +
∆yi).
 A decline in the desired output level
• PRINCIPLE decreases investment even to a level
 The level of investment is a of zero if the actual stock of capital is
more than enough to meet declining
function of desired changes in output levels.
output.  Investment spending is now treated as
endogenous variable of income.
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 D. INVESTMENT DEMAND
DETERMINANTS
(3) INNOVATIONS
• Long run factor that shift the investment
demand curve.
• JOSEPH SCHUMPETER
 describes innovation s the
introduction of an unfamiliar product
and untested technology, opening a
country’s products to markets and
sources of raw materials not previously
encountered and the setting up of new
organization in any industry.
• It can create demand for products
including capital goods and usher the
acceleration process between income
and investment.
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D. INVESTMENT DEMAND
DETERMINANTS
(4) PROFITS;
(5) EXPECTATIONS
• PROFITS:
Basic reason why business invests
 PROFIT TRENDS which Influence
business investments in long-run.

• EXPECTATIONS:
Types of Businessman
 Mediocre Businessman
 Perceptive Investor

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E. INVESTMENT
DEMAND-
SUPPLY
AND
FOREIGN
BORROWINGS

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 E. INVESTMENT DEMAND-SUPPLY AND
FOREIGN BORROWINGS
• ILLUSTRATION:
 Prevailing interest rate at the natural level of re
(investment demand = supply)
 Monetary Authorities prohibited transactions
above the official interest rate level of re which
was pegged way below the market rate re.
 Unrealistically low official interest rate level
encouraged borrowings beyond what savings could
provide and led demand to exceed supply.
• Local supply-demand curve constraints
may induce the economy to tap external  Unable to compete for scarce funds and higher
rate = Borrowers resorted to Foreign Borrowings.
sources of funds which traditionally was
the case of Philippines because of the • RESULT:
unrealistic interest rate ceilings pegged by  ↑ Net Foreign Borrowings and Gross
the government in ‘70s and ‘80s. Accumulation
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F. INVESTMENT
AND
THE
BUSINESS
CYCLE

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 F. INVESTMENT AND
THE BUSINESS CYCLE
• INVESTMENT
(+) Creates a multiplier effect
inducing output and durability
of capital
(-) Strong Element of Instability
in the economy
 Instability = in the form of
business cycle which is evident
when the economy’s pace of
innovation is slow.

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 F. INVESTMENT AND THE BUSINESS CYCLE
(1) BUSINESS CYCLE CONCEPTS
 BOOM
 peak of this upturn.

 RECESSION
 follows recovery with reverse trends
in production, investment, employment,
income, production, capacity utilization
and price.
 RECOVERY
 ↑ Real GNP  DEPRESSION
 Influenced by multiplier effect of  general investment climate as too
Investment weak to stimulate economic activities.
 ↑ Employment, Income, Production  Economy reaches rock bottom.
Capacity Utilization, and Price
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 F. INVESTMENT AND THE
BUSINESS CYCLE
(2) DURABILITY OF CAPITAL:
A SOURCE OF INSTABILITY
• ASSUMPTIONS:
a. Price level is constant
b. Ratio of expenditure is equal to 2
c. Price capital is equal to 2
d. Marginal Propensity consume is 0.50 and
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. 30
F. INVESTMENT AND THE BUSINESS CYCLE
(2) DURABILITY OF CAPITAL:
A SOURCE OF INSTABILITY

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APPLICATION

32
 SURPRISE GROWTH: 6.2%
Doris C. Dumlao
PHILIPPINE DAILY INQUIRER
August 31, 2004
• CAUSE OF INCREASE IN APRIL-JUNE
 Election Spending
 Higher Usage of Cellular Phones
• EFFECTS
 ↑ GDP = 6.3% Total Value of produced and
services; higher from last year 4.5%
 ↓ GNP = 5.7% Net Factor Income from Abroad.;
lower from last year 6.5%
• WHY IS THE ECONOMY GROWING?
 An economy can grow despite the government’s
huge public deficit and debt burden because growth
in key sectors can still lift up the economy.
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34
Thank You