Unit 16: Investment

Question 1

Investment

Answer 1

Expenditure by firms to increase productive capacity i.e. additional to capital stock with the expectation of generating future returns or income

Question 2

Types of Investment

Answer 2

1. Residential - spending by households/firms on residential property to be utilized or rented out to others
2. Non-Residential - spending by households/firms on machinery, commercial real estate, tools, etc. to add to capital stock.
3. Inventories - it represents a form of capital that businesses hold to support production and sales, it is an asset that contributes to the production process or can be sold to generate revenue making it a crucial part of business operations.

Question 3

Paradox of Thrift

Answer 3

While saving is beneficial for the individual, an increase in overall saving in an economy can lead to negative outcomes such as lower income and economic contraction

Question 4

Effects of Investment

Answer 4

1. Long-term Economic Growth
2. International Competitiveness

Question 5

Long-term Economic Growth

Answer 5

Investments leads to an increase in the quality or quantity of capital, which is a factor of production, this shifts the PPC or the AS curve outwards, allowing AD to increase further without putting pressure on prices

Question 6

International Competitiveness

Answer 6

Investments lead to an increase in the quantity or quality of capital, this reduces average costs for a firm leading to lower market prices. Lower market prices means that exports increase and imports increase as the prices of domestically produced goods are relatively cheaper compared to goods produced in other countries, this leads to the number of exports exceeding the number of imports, which creates a current account surplus in the economy.

Investment can also lead to non-price competitiveness as higher quality goods may be produced

Question 7

The Multiplier

Answer 7

an initial injection (investment) in an economy, leads to overall greater increase in national income, national income will increase by a multiple of the increase in investment.
The multiplier (k) is the number of times by which the change in income exceeds the size of the initial expenditure/injection

K=change in Y/change in I
k = 1/MPS

a change in investment brings about a larger change in national income

Question 8

Strengths of the multiplier

Answer 8

1. it helps policy makers understand how fiscal interventions can stimulate economic growth
2. it provides a basis for calculating the potential impact of public spending on GDP

Question 9

Critique of the Multiplier

Answer 9

1. Crowding out effect
2. Inventories
3. Fiscal Drag

Question 10

Crowding out effect (critique of multiplier)

Answer 10

1. Resource Crowing out - by increasing investment, the government would be taking away resources from the private sector, leading to a reduced investment from the private sector
2. Financial crowding out - government sells bonds as a means to borrow money, to attract financing they increase interest rates, this diverts people’s savings from the private sector to the public sector

Question 11

Inventories (critique of multiplier)

Answer 11

If aggregate demand increases, firms may initially meet this demand by drawing down inventories rather than ramping up production. this dampens the immediate impact of increased spending on output and employment,, reducing the size of the multiplier effect. Additionally if the increase in demand is perceived as temporary, then, firms see the demand as unsustainable and they may refrain from increasing production.

Question 12

Fiscal Drag (critique of the multiplier)

Answer 12

the higher the income, the higher the tax rate, which will offset some of the expansion of income

Question 13

Determinants of Investment

Answer 13

1. Interest Rates
2. Expected net rate of return (Present Value Approach)
3. Marginal Efficiency of Capital
4. Expectations
5. Spare Capacity
6. Technological innovations
7. Availability of finance
8. Stability

Question 14

Interest Rates

Answer 14

a high interest rate means that it will be more costly for firms to borrow money in order to finance its investment projects. The firm may resort to internal financing (retained profits) to finance investment, an increased interest rate makes saving money more attractive (buy bonds or deposit money in bank)

Question 15

Present Discount Approach

Answer 15

whether to invest or nit depends on the future earnings and cost of investment. The present value approach is a way of figuring out how much a future amount of money is worth today. since money today is more valuable than money in the future, we discount the future money to reflect its lower value today. When making a decision about investment we must calculate its future earnings and discount them to give them present valuation

NPV=PV-C
FV=PV(1+r) to the power of n
PV = sigma Rn/(1+r)n
Real r = nominal r - expected rate of inflation

Question 16

Marginal Efficiency of Capital

Answer 16

the rate at which future earnings must be discounted in order to make their present value equal to the current cost of capital i.e. supply price
if MEC>r, Investment will generate a profit
if MEC<r, Investment will incur a loss

C=sigma Rn/(1+MEC)n

Question 17

Diminishing Marginal Returns of Capital

Answer 17

Marginal efficiency of capital falls with higher investment, a rational consumer will invest up until I=r

Question 18

Why is Investment so Volatile?

Answer 18

Accelerator Theory

Question 19

Accelerator Theory

Answer 19

a change in income exerts a powerful effect on the level of income, investment by firms is influenced by changes in demand for commodities. When demand for commodities increases, firms are likely to increase their investment to meet that demand

alpha = induced investment/changes in income

assumes constant capital-to-output ratio

Question 20

Replacement Investment

Answer 20

refers to the spending that businesses make to replace or maintain their existing capital stock e.g. machinery, equipment, etc. This type of investment is necessary to keep the company’s production capacity at its current level.

Question 21

Induced Investment

Answer 21

refers to the type of investment that occurs as a direct result of changes in demand for commodities in an economy. when demand for a firm’s commodities rises, firms are likely to increase their investment capital to meet higher demand

Question 22

Growth rate of national income and accelerator theory

Answer 22

If growth rate of national income increases, then, investment increases

If growth rate of national income increases at a diminishing rate, investment falls

if growth rate of national income increases at a constant rate, investment remains the same

Question 23

Advantages of Accelerator Theory

Answer 23

1. it explains why investments fluctuate in response to changes in economic output
2. policy makers use the theory to anticipate investment needs based on economic growth trends

Question 24

Critique of Accelerator Theory

Answer 24

1. Inventories
2. Perception of future AD
   3.Long time to plan investment
3. Technology can change the capital-to-output ratio

Question 25

Inventories (critique of accelerator theory)

Answer 25

The theory, assumes that firms will immediately adjust their investment levels in response to changes in national income. However, businesses often rely on their inventory levels as a buffer against short-term fluctuations in demand. If a firm is able to maintain as sufficient inventory, it might nit need to increase investment even if there is a rise in national income. this can cause a lag in investment response.

Question 26

Perception of future AD (critique of accelerator theory)

Answer 26

if firms perceive that the increase in national income is temporary, they may choose to delay investment despite current growth.

Question 27

Long time to plan investment (critique of accelerator theory)

Answer 27

capital investments often take time to plan and execute. Even when national income rises, firms may take time to make decisions and deploy investments. The theory’s assumption of an immediate response is therefore realistic

Question 28

Technology changes capital-to-output ratio (critique of accelerator theory)

Answer 28

technological advancements can significantly change the efficiency with which capital is used. New technology can lower the need for additional capital investment relative to the output produced, leading to changes in the capital-to-output ratio.