Investment A. Introduction Economists have long recognized that investment tends to be the most volatile components of expenditure over the business cycle. As a result, investment expenditures play a key role in many theories of the business cycle, including Keyness theory. Macroeconomic theorists have agreed on a basic framework that models the investment strategy of a profit-maximizing firm. However, empirical evidence has failed to provide substantial support for this model, which has been a source of frustration for those involved in investment modeling. What is investment? The term investment means something different to economists than it does to most of the rest of the world. For example, if you ask your banker about investment, she will probably start talking about stocks and mutual funds that she would like you to purchase, or new kinds of deposit accounts that her bank offers. To an economist, these purchases of financial assets are not investment from a social point of view because financial assets do not represent real net wealth for the economy as a whole. Instead, they reflect credit relationships within the economy. Financial assets such as loans and bank accounts represent contracts to pay interest and repay principal on borrowed money. Stocks represent partial ownership of a corporation, implying a right to vote on the governance of the corporation and to receive dividends as determined by the directors that the shareholders elect. In either case, the financial asset of one individual in the economy is offset by a financial liability of another person or corporation. Thus, when we aggregate the wealth of all members of the economy, these assets and liabilities cancel and financial assets disappear. Thus, if you invest in a financial asset, someone else is disinvesting at the same time, so aggregate, or social, investment does not rise. Economists usually reserve the term investment for transactions that increase the magnitude of real aggregate wealth in the economy. This includes mainly the purchase (or production) of new real durable assets such as factories and machines Strictly speaking, investment is the change in capital stock during a period.. Note that: Capital stock- the amount of capital that we have at a given time (a stock concept) Investment-the amount we add to capital stock in a given time (a flow concept) This means that while capital is measured at a point in time, investment can only be measured over a period of time. Autonomous and Induced Investment, D N Dwevedi, Page 173 (Book) Why we care about Investment? Investment drives capital formation, and the stock of capital is a key determinant of output and consequently feasible consumption levels. i.e., investment demand is potentially important to the behavior of standards of living over the long-run Investment is the most volatile component of GDP. Investment therefore is the most important proximate source of business cycles. Government policy is typically targeted heavily on investment; most tax codes favor it Methods of Investment Decisions The theory of Investment is essentially the theory of demand for capital. Refer the formulae your notes Or For more Book page 173 Net Present Value Method The NPV method is one the popular methods of taking decision investment projects. Assumptions: The firm is maximizing the PV of profit The firm is forward looking and involve the effect of current decisions on future opportunities The firm is operating in a competitive markets (all markets are competitive) No uncertainty (no difference between actual and expected profit) Given this assumptions, the determinants of the desired capital stock can be derived from the present value maximization of firms expected future profit stream. The net present value(NPV) is defined as the difference between the present value(PV) of a future income stream and the cost of investment (C) i.e. NPV=PV-C OR Present Value of Future Income, for more Book, Page 173 as per our discussion in class. Decisions -If NPV is greater than C, then project under consideration is worth investment.Here its beneficial for the investor to borrow at market rate of interest and make investment -The optimum level of investment is reached where NPV=0.In case NPVi, then the investment project is acceptable If MEC=i, then the project acceptable only on non profit considerations If MEC1) Now let the demand for output increase in period t+1 to Y t+1. Then the increase in demand can be expressed Y t+1=Yt+1-Yt To produce change output Y t+1 they are required to increase the their desired stock of capital in period t+1. Given the capital output ratio (k) and additional demand for output Y t+1,the desired capital stock (Kt+1) in period t+1 is given as Kt+1 =kYt+1 Now the change in capital stock K=I(net investment).Therefore Kt+1=It+1 then the above equqtion can be written as It+1=k( Yt+1) Therefore This accelerator Theory of investment formula shows investment is a function of the change in the level of income (or output) Decisions If Yt+1-Yt>0,then It+1>0 If Yt+1-Yt=,then It+1=0 If Yt+1-Yt