Investment Function

What we will learn in investment function.

● The chapter presents investments as a process of building up the
capital stock, the expenditure for which determines income and
production.
● It also shows the factors which can facilitate or constraint
investment contribution to the circular flow.
● Subsequent discussions focus on savings as a leakage from the
circular flow which can be channeled back to the system as a basic
source of investment spending.
What we will learn in investment function.
● The chapter will also discuss the relationship between investment
demand and supply reflects the interplay between investment
factors which can alter the savings-investment equilibrium and
change the flow of economic activities.
● Lastly, the chapter explains the acceleration principle which
illustrates investment more realistically as an endogenous factor of
income and production.
INVESTMENT: A DETERMINANT OF INCOME

Basic Concept of Investment

● Investment expenditure is capital spending mainly derived not from
current income and consumption but from accumulated savings and
other sources of external to the circular flow.
● Investment expenditure refers to the expenditure incurred either by
an individual or a firm or the government for the creation of new
capital assets like machinery, building etc.
INVESTMENT: A DETERMINANT OF INCOME

● Investment increases the capital stock and the expenditures for

which generate income as inflows to the system.
● Investment expenditure is an endogenous variable as income affects
and creates a multiplier effect on the level of investments.
● Investment spending is a long term consumption.
INVESTMENT: A DETERMINANT OF INCOME
Consumption Expenditure Investment Expenditure
● It is spending on current ● It is spending on capital
consumption or goods which are repeatedly
consumption of non-durable used and gradually
goods. consumed over a long
period of time as durable
goods.
INVESTMENT AND THE MULTIPLIER
INVESTMENT AND THE MULTIPLIER
The table shows the equilibrium income is 500 assuming that consumption is its
only component because households are the only factor contributors and personal
savings is the only leakage from the system.

However, the inclusion of investment equals to 80 increase income to 900 and

the additional income of 400 is equal to investment plus the additional consumption
it generates.

INCOME = CONSUMPTION + INVESTMENT C+I

400 420 80 500

900 820 80 900

INVESTMENT
AND OUTPUT
 BASIC CONCEPTS

While current depreciation decreases

Business and household
total output in the short run, current
investments tend to increase
investment only yields output in the
the economy's stock of
long-run for two reasons. First, after
capital and total output. total investment expendure to meet,
Whereas depreciation has production targets has already been
the opposite effect as it incurred, the process of setting up and
represents capital even, testing the capital base -creates
consumption. operation legs. Second, every phase in
setting up a capital base may not be
capable of independent utilization until
INVESTMENT
AND THE STOCK
ADJUSTMENT Despite the
investment-production time
PROCESS Iag, sustained investment
patterns can determine
trends in the capital stock
and production level over a
long period.
 where:
It should be understood at this point that
K = Stock of capital after depreciation and investment.
capital stock is not a headcount but rather
K =f Initial stock of capital, before depreciation and
the aggregate production capacity of investment
existing capital goods in the economy D = i Depreciation

which can diminish due to usage and I = Investment

Y = Initial output from the capital stock, before
depreciation. However, investment
investment
i and depreciation
increases the stock additional capital
Y = Total output from the capital, stock after
brings additional production capacity. depreciation
f
and investment
The following framework illustrates Δy = Change in total output because of depreciation
investment-output relationship assuming a
d
Δy = Change in total output because of investment
i
short-run time frame, no investment-production a = Output-capital ratio (Y/K)

time lag, and constant capital output ratio:

furthermore: d i
f i
Net change in capital stock = (-D + I)
K=(K-D+I) Net change in output = (-Δy + Δy )
i
f i d i

Y= (Y- Δy + Δy) = a(K-D + I)

SAVINGS AS A
SOURCE OF
Savings is the unspent portion of income
INVESTMENT
during the period intended for spending as
SAVINGS CONCEPT
in the case of a salary earner who sets aside
a portion of his pay earmarked for the next
fifteen days. It is a residual of income which
into a stock for future use and postpones
current consumption.
SAVINGS-INVESTMEMT
EQUILIBRIUM
The economy is in equilibrium at that point where
savings is equal to investments. According to this
approach the equal level of income is determined
at a point where planned savings and planned
investments are equal to each other or S=I.
If S>I If S<I
Determinants of Savings
 National Income
The sum total of the value of all the goods and services
manufactured by the residents of the country, in a year., within
its domestic boundaries or outside. It is a net amount of income
of the citizens by production in a year.

Price Levels
The average of current prices across the entire
spectrum of goods and services produced in an
economy.
 Population Growth
The increase in the
number of people in
a population.
 INVESTMENT DEMANDS
DETERMINANTS
Interest rate
When interest rates rise, it becomes more “expensive” to borrow
money. That borrowed money would typically go toward consumer
expenditures and capital investment, and so these two sectors
diminish under higher interest rates. Therefore aggregate demand
decreases, per the equation.
When interest rates fall, the opposite happens. Businesses and
individuals are able to borrow money at affordable rates. This
borrowed money is invested in consumer purchases and capital
(such as real estate or start-up business
The Acceleration,
Innovation and
Profit
 The Acceleration Principle
-the level of investments is a function of desired changes in
output

Yi= (Yi-yd+yi) =a (Ki-D+I)

Innovations
-Innovation can create demand for products including capital
goods and usher the acceleration process between income and
investment.
Profit
-is the money earned by a business when its total revenue exceeds its
total expenses.
 Expectations

Expectations are sets of ideas laid down to serve as a

barometer for the growth of any businesses, sectors, and
organizations. Businessman simply views the future as a
continuation of the past trends.
CASE 1: Victoria Sugar Mills
The management of Vicoria Sugar Mills when they
anticipated sluggish world market fo sugar in the early
‘70s. The company invested to diversify its product
line before sugar prices went down to very low levels
in 1983 and brought losses which had paralyzed the
sugar industry. The anticipation of this turning point
saved this company from a business catastophe.
 Case 2: Windfall Investments

Windfall investements in real assets like lands,

appliances, and the like in 1984 which brought gains to
some businesses during the first year of the economic
crisis. For one, potential inestors began to speculate on
real properties because of their fast rising values instead
of keeping idle bank depsits whose real values inflation
only erodes. On the other hand, the temporary boom was
also due to mass expenditures on household real assets
such as appliances because of the “now or never”
attitude likewise spurred by rising cost expectations.
 Investment Demand-Supply and
Foreign Borrowings

Local supply-demand contraints may induce the

economy to tap external sources.

FIGURE 42: INVESTMENT DEMAND AND SUPPLY

It illustrates that the prevailing interest rate cpuld otherwise
be at the natural level of re where investment demand would
equal supply.
 Investment and the Business Cycle

Investment creates a multiplier efdect

of inducing output, the durability of
capital can introduce a strong element
of instability in the economy.
Business Cycle Concepts
Aggregate economic activity has a cycle of ups and
downs as the trends in Real GNP indicate.
Phases of Business Cycle
► RECOVERY
is the phase that employment, income, production capacity
utilization and price increases.
► BOOM
where labor are fully employed at high wages, cost of doing
business increases, the tension in the money market
increases.
► RECESSION
follows recovery with reverse trends in production, investment,
employment, income, and price. Profits decline.
► DEPRESSION
is the worst economic downturn where in an economy is in a
state of financial commotion. It is a lot worse than a recession.
Durability of Capital: A source of instability

Assumptions:
A. Price level is constant implying that variations in the desired
expenditure level indicate changes in the desired production level.
B. Ratio of expenditure to capital stock is equal to 2.
C. Price of capital is equal to 2.
D. Marginal propensity to consume is 0.50 and, therefore, the 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.
Why Capital Durability plays Table 17
an important role when it
comes to the stability of our
economy?

Capital Durability is important to supply the

needs on the production, provides
subsistence or living to the workers while
they are engaged in production and at the
same time it provides employment. If it
happens, it increases productivity, more
goods can be produces with the aid of
capital. Then because of raising productivity,
capital occupies a central position in the
process of economic growth.
 Surprise Growth : 6.2%
Doris C. Dumlao
Philippine Daily Inquirer, August 31, 2004

Election spending and higher usage of cellular phones

allowed the Philippine economy to grow by 6.2 percent in
April - June despite the government's fragile fiscal position.
The country's gross national product (GNP), which
combines the GDP with net factor income from abroad,
grew by a slower 5.7 percent in the second quarter, down
from 6.5 percent a year ago.
This was due to the "negligible" 0.3 percent growth in net
factor income, which includes remittances from Overseas
Filipino Workers (OFWs), according to the National
Statistical Coordination Board (NSCB).
THANK YOU.