Advanced Macroeconomics Lecture: Investment Demand Date:

Investment The value of that part of the economy’s output for any time period that takes the form of new structure, new producers’ durable equipment and change in inventories Inventories Stocks of goods held by business in production -Materials awaiting use -Goods in process -Finished products awaiting sale to the distributors or final users

Investment The decision to invest depends on prospective profitability which is determined by three elements -The expected income flow from the capital good -Purchase price of that good -The market rate of interest

Investment Involves uncertainty -The amount of income the good will generate -The time period -Technological change -Purchase price, larger deviation in reality than the anticipation

Investment Price, time and interest rate If someone lends P 0 amount for 1 year hence P 1 =P 0 (1+r) Where, P 1 =Return for the second year P 0 = Amount lent r= Rate of interest If consider the time period to be n year then P n = P 0 (1+r) n

Investment Present value method To find out the present value of a future sum P 0 =P 1 /(1+r) Hence for the nth period of time, v=R 1 /(1+r)+R 2 /(1+r) 2 +R 3 /(1+r) 3 +…….+R n /(1+r) n +A Where, A is the face or principal amount

Investment Now, the cost of capital is given and the future income stream is given then it is possible to find out interest rate i that will make the present value of the income stream just equal the cost of capital, hence C= R 1 /(1+r)+R 2 /(1+r) 2 +R 3 /(1+r) 3 +…….+R n /(1+r) n Here i is different from the market rate of interest r

Investment If C=$ and income stream $100 each year for five years then $427.02= $100/(1+r)+ $100 /(1+r) 2 + $100 /(1+r) 3 +…….+ $100 /(1+r) 5 Solving this equation we get i=5.5 percent The rate that will make the present value just equal to the cost is termed as Marginal Efficiency of Capital(MEC) according to Keynes

Investment Comparing MEC with market rate of interest rate, the profitability of investment could be measured The difference between MEC and r is the net rate of return after allowance of all costs including interest payment If income flow increases then MEC increases A drop in price of capital goods increase MEC

Investment Marginal efficiency of Capital for a firm MEC,r Stock of capital

Investment Marginal Efficiency of Investment (MEI) schedule indicates the rate of investment spending per time period at each possible market rate of interest

Investment The process of capital accumulation in response to the fall in interest rate Gross investmentStock of capital MEC,r MEI,r MEC MEI

MEI Marginal Efficiency of Investment (MEI) schedule indicates the rate of investment spending per time period at each possible market rate of interest Businesses typically compare the MEI on physical capital with interest rate returns on financial capital when deciding to undertake an investment project.

MEI Curve Different investment projects have different returns, Often have a range of alternatives projects from which to choose. Combining all projects throughout the economy gives rise to an investment demand curve relating investment expenditures to the interest rate.

MEI The MEI curve represents the interest elasticity of demand for investment (or capital goods), or in other words, how responsive investment is to a change in interest rates. Interest rates represent the cost of borrowing. Theoretically, the lower the rate of interest, the cheaper it is for firms to finance investment, and the more profitable the investment will be. Hence, the level of investment will rise.

MEI Keynes- investment is in fact relatively unresponsive to changes in interest rates, particularly at the extreme ends of the Trade Cycle. During a recession, businessmen are generally pessimistic about the future outlook Excessive unused productive capacity, which prevents a fall in interest rates from stimulating I.

MEI During a boom, optimism may cause them to disregard high interest rates. Hence, MEI is more likely to look like the relatively inelastic MEI 1 than the relatively elastic MEI 2.

MEI MEI 2 MEI 1 Interest rate Investment I I r1r1 r2r2

MEC Keynes instead emphasized the importance of expectations (entrepreneurship mood), Expectation is affected by the state of the market for their product (which is in turn determined by factors like political stability, cost of production, conducive business climate etc). The expected rate of returns from investment is measured by Marginal Efficiency of Capital (MEC).

MEC MEC is a downward sloping curve because, as the firm invests more, MEC will fall due to diminishing returns (i.e. the first few projects invested in tend to give a higher rate of returns, with subsequent projects yielding lower and lower returns).

MEC I2I2 I1I1 r1r1 r2r2 MEC,r Investment

MEC in investment decision The decision to invest is determined by a comparison of MEC and the opportunity cost of the investment (i.e. interest rate). As long as the MEC is greater than interest rates, firms will invest more (i.e. the project is regarded as worthwhile).

MEC in investment decision It will stop investing when the MEC = r. Hence, as seen in the above diagram, if interest rates fall from r 1 to r 2, projects with lower expected returns, seen previously as unprofitable, will NOW appear viable, and so, more I will occur. This increases I from I 1 to I 2.

Shift of MEC Increasing optimism translates into higher expected returns and the MEC can shift to the right. Similarly, a collapse of business confidence causes a downward revision of future returns and the MEC curve shifts to the left.

MEC Hence, a rise in interest rates may not dampen I if, at the same time, MEC has increased.