Topic #2:
Investment
I. Introduction to Concepts
Whenever new machines, factories, plant and equipment, tools, and structures are
produced and sold, we say that fixed investment has taken place. Sometimes it is as
small as a company buying a new light bulb. Sometimes it is as large as the
construction of a new production line. Real net fixed investment occurs when there
is an increase in existing physical capital. This will happen if gross fixed investment
is greater than depreciation. We write this as
Real net fixed investment = Gross real fixed investment – real depreciation
Sometimes we refer to depreciation as capital consumption allowance. Nominal
investment is just real investment multiplied by the price index of investment.
Fixed investment does not take place when an existing machine or factory is sold from
one owner to another. In that case, we say that there has merely been an exchange of
existing assets. Therefore, whenever a person sells corporate stock to another person
on the secondary market or stock exchange, this is not investment as economists use
the word. It is an sset transfer only.
In addition to fixed investment, total investment also includes changes in inventories.
For example, if inventories on December 31, 2002 equaled $1000 and if inventories
on December 31, 2003 equaled $1100, then annual inventory investment for 2003
equaled to $100. It follows that
Total Investment = Total Gross Fixed Investment + Total Inventory Investment
and
Total Gross Fixed Investment = Total Net Fixed Investment + Depreciation
Investment is a flow. It is not a stock, although the amount of capital in the economy
is certainly a stock. Investment is the change in this stock of capital. Within a
fixed period of time, anything that increases the stock of capital, increases the flow of
investment. Investment can be separated into domestic investment and net foreign
investment. Net foreign investment represents an increase in foreign capital owned
by domestic residents. Investment can also be divided into private investment and
public investment. A highway is an example of public capital. Any increase in
public capital takes place as public investment.
Some countries (e.g., the US) count
public investment in G = government spending.
public investment in I=total investment.
Other countries (e.g., Taiwan) count
II.
Theories of Investment
There are three basic theories of investment that have become popular over the years.
The first was introduced by Keynes in the General Theory in 1936. The second was
proposed by D. Jorgenson of Harvard during the 1960's and is referred to as the
neoclassical theory of investment. The last theory was developed by J. Tobin of Yale
and is known as the q-theory.
Keynes focused attention on the investment function because he believed that
fluctuations in real GDP and employment were mainly due to the unpredictable
changes in investment. These unpredictable changes were due to abrupt changes in
the psychological expectations of businesses. Keynes felt that the decision to
purchase new capital depended on the cost of new capital, the expected stream of
future profits expected to be earned by the new capital, and the current long run rate
of interest. Anything which affected these three variables could be expected to alter
the desire to invest. For example, if prior heavy investment lowered the productivity
of potential new capital, this would lower expected profits and thus lower current
investment demand. Also, if heavy investment raised the cost of new capital goods,
then this would also lower investment. Naturally, a higher real rate of interest would
lower real investment. At times, Keynes introduced interesting situations, such as a
fall in nominal wage rates, as in Chapter 19. He stated that this would increase
investment, but if wage rates were expected to continue to fall, then this would lower
investment. The reason for this is that future investment in capital goods would be
done at a lower cost and this would mean that current capital would have to compete
with future capital requiring a much lower level of profitability.
Keynes defined the marginal efficiency of capital (MEC) as the rate of discount that
would equate the stream of future expected net revenues from an additional unit of
capital with its current supply price. We often write this as:
N
Pc  
t 1
E ( Rt  Ct )
(1  m e )ct
where Rt = revenue and Ct = cost.
Keynes felt that confidence would also affect this mec. How could it do this?