Investment

Gross investment: Have 2 components these are

Gross fixed capital formation also called planned investment- it accounts for spending on new fixed assets such as machinery, factory plants, vehicles and other capital goods which enable increased production of goods and service in future time periods.

Changes in inventories- inventories are the stock of finished goods, unfinished goods or work in progress which firms possess. Change in inventories result when aggregate demand for final goods differs from the aggregate volume of output produced. If aggregate demand for the goods is less than the aggregate volume of output produced, then inventories would increase. This component of investment is unplanned.

Actual or gross investment = gross fixed capital formation + changes in inventories

This means that the level of actual investment in the economy would be given by the level of gross fixed capital formation (planned investment) and the level of changes in inventories (unplanned investment).

Net investments

Net investment refers to the true addition to the national stock of capital that can be utilized to move the economy forward.

Net investment = gross investment – capital consumption.

Accelerator theory

This is the relationship of the rate at which national income changes and the effect on net investment.

The volatility of investment

Why does investment expenditure fluctuate?

In contrast to consumption, investment is generally unstable and can even tend to move unpredictably. In fact it is probably the most volatile component of total expenditure. Several reasons have been offered as explanations for this variability in investment.

They include:

1) The durability of capitals 2) The irregularity of innovation3) The variability of profits 4) The variability of expectations

Durability of capitalCapital goods can have a lifespan that is indefinite. Consequently, changes in the level of investment are, to some extent, discretionary and therefore postponable. If firms are optimistic about the future, they will tend to replace existing capital and even to modernize their plants. However, if firms are not so optimistic they will operate for repairing rather than replacing.

Irregularity of innovationAny major innovation or technological breakthrough automatically increases the level of investment. E.g. cellular phones, wireless internet. New productions and new processes provide a significant stimulus for investment, but major breakthroughs occur irregularly and inconsequence investment expenditure would follow that same trend.

Variability of profitFirms only invest when they expect the investment to be profitable. Further, if current profits tend to fluctuate, investment would also fluctuate because profits are a major source of funds for business investments.

Variability of expectations This covers expectations about the political climate, about changes in the exchange rate and changes in the population and these expectations are likely to impact on the level of current investment.

Marginal efficiency of capital (MEC)

There is no universally acceptable theory of investment neither is there a complete theory of investment. The (MEC) is a theory which seeks to explain how investment is determined. With investment, it is necessary to place a value on the expected stream of future earnings in order to compare this to the current cost of acquiring the capital asset. This process is referred to as discounting. Discounting is in effect when; a process by which the future stream of net returns expected from an asset must be assigned a value which can then be compared to the current cost of the asset.

Generally, assets are discounted to their present value so that if the present value of the future stream of net returns is greater than the current cost of the asset, the investment will be profitable. The Keynesian approach to investment is not to discount to present value, but rather, to discount based on the MEC i.e. the rate of discount which brings a stream of future earnings in equality with the current cost of capital. If therefore the current cost of borrowing funds (rate of interest) is less than the MEC, then the investment is expected to be profitable.

However, if the MEC < interest rate, the investment will be unprofitable. If MEC is exactly = to the rate of interest, he firm will experience neither a loss nor a gain. If we aggregate the MECs for different investment projects, the resulting MEC schedule will be downward sloping. In effect, what it shows is the demand for capital at different rate of interest.

MEC and interest rate(IR) more capital is demanded as the interest rate fall

P1 (inverse relationship)

P2

0

Q1 Q2 investment / capital

A diagram of the MEC curve

Although there is no doubt that changes in the rate of interest influence investment decisions, it is not very likely that it is the main determinant of investment. There are many reasons for this and these include:

Public sector investment is usually undertaken for social, rather than economic considerations. In reality, it is extremely difficult to estimate the MEC. Expectations can sometimes exert a powerful influence on investment decisions, irrespective of

the rate of interest. Large firms tend to plan over some time period and changes in the rate of interest occurring

after investment plans have been set in motion are unlikely to persuade the firms to revise their investment plans.

n.b the marginal efficiency of capital MEC is a percentage which gives return on capital employed. The marginal efficiency of investment MEI is a percentage which gives the return on investment. Investment, of course, is given by the change in the amount of capital employed.