Session 06

Investment Spending
(GDP=C+I+G+X-M)

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 Why is Investment Important?
Investment (I) is a significant and volatile component of aggregate demand
GDP = C + I + G + X – M
India’s GDP at Market Prices in ₹ Bn, 2004-05=100
C I G X M GDP
1960-61 3577.95 728.88 254.73 188.91 337.92 4360.37
(%) (82) (17) (06) (04) (08) (100)
1970-71 4776.97 1161.72 613.70 287.59 326.85 6443.89
(%) (74) (18) (10) (04) (05) (100)
1980-81 6615.62 1792.91 951.96 606.14 640.51 8663.40
(%) (76) (21) (11) (07) (07) (100)
1990-91 10008.67 3630.29 1834.88 1008.88 1150.94 14876.15
(%) (67) (24) (12) (07) (08) (100)
2000-01 15792.01 6262.08 3247.27 3232.88 3901.32 25540.04
(%) (62) (25) (13) (13) (15) (100)
2010-11 30923.73 21019.36 5835.45 11950.03 15424.28 52823.84
(%) (59) (40) (11) (23) (29) (100)
2017-18 74174.89 44791.09 13785.63 26073.10 30835.60 131798.57
(%) (56.3) (34.0) (10.5) (19.8) (23.4) (100)
2018-19 80166.74 48808.69 15060.35 29339.69 35579.01 140775.86
(%) (56.9) (34.7) (10.7) (20.8) (25.3) (100)
Data for 2017-18 & 19 are provisional and at 2011-12=100; Differences, if any, in the total figure show statistical discrepancies.
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 What is Investment?

• Investment links the present to the future.

• Investments link the money markets to goods markets.

Monetary policy affects the economy through interest rate
sensitive investments.

• Fiscal policy in the form of lower taxes on capital can directly

increase investment.

• Investment drives much of the business cycle.

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 Investment
• The theory of investment is the theory of the demand for
capital.
– Investment is the flow of spending that adds to the stock of
capital.
• Both GDP and investment are flow variables.
– Capital is the rupee value of all the buildings, machines,
and inventories at a given point in time  stock value.
– Investment is the amount spent by businesses to add to the
existing capital stock over a given period
• Flow of investment is quite small compared to the stock
of capital
• Investment over long periods determines the size of the
stock of capital and thus determines long-run growth.
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 Components of Investment

• Business fixed investment

o Public
o Private
• Household residential investment
• Inventory investment
o Unanticipated
o Anticipated

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 Investment, Govt. Budget and Trade
GDP = C + I + G + X – M (production)
Y+B =C+S+T (expenditure)
Y = C + S + (T-B)
C + I + G + X - M = C + S + (T-B)
(I - S) = (T-G-B) + (M - X)
I = S + (T-G-B) + (M - X)

Gross domestic investment = gross private savings + gross govt

saving + borrowing from abroad

Hypothetical Wheat Economy

Investment (I) is the leftover wheat that will be planted for next year’s
crop. The sources of wheat investment are wheat saved by individuals
(S), any wheat leftover from govt tax collections net of govt spending (T-
G-B), and any net wheat imported from abroad (M - X).
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 I = S + (T-G-B) + (M - X)
Investment must be financed from three sources – Private
Saving, Govt. saving, borrowing from abroad

• A fiscal deficit must be financed by lower I, higher private S,

or increased net imports.

• An increase in private S will lead to increased I, an increased

fiscal deficit, or a decline in net imports (increase in net X)

• A decline in net exports (an increase in net M) is associated

with lower domestic savings, a larger fiscal deficit, or
increased I.

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 Investment Function
Investment demand schedule
Firms use capital, along with labor and other resources, to produce output. The
goal of a given firm is to maximize profits.

• When deciding the optimal level of capital, firms must balance the contribution that
more capital makes to their revenues against the cost of acquiring additional capital.

• The marginal product of capital is the increase in output produced by using one more
unit of capital in production.

• The rental (user) cost of capital is the cost of using one more unit of capital in
production.

Investment demand depends on the annual revenue from an

investment and cost of capital (i.e., interest rate).

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 The Desired Stock of Capital

• Firms add capital until the marginal return of the last unit = rental cost of capital (rc).
– Diminishing marginal product of capital
– An increase in the rental cost of capital can only be justified by an increase in the marginal
product of capital and a lower level of K
– Higher output, business optimism, advancement in technology, lower tax rates and input
prices shift the schedule upward.

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 Theories of Investment
• Marginal productivity of capital
The marginal product of capital is the increase in output produced by using
one more unit of capital in production. The rental (user) cost capital is the
cost of using one more unit of capital in production.

The firms will keep investing until the value of the output produced by
adding one more unit of capital is equal to the cost of using that capital –
the rental cost of capital.

• Marginal efficiency of capital (MEC)

MEC is that “rate of discount which could make the present value of the
series of annuities given by the returns expected from the capital asset
during its life just equal to its supply price”.

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 Why MEC slopes downward?

MEC
(r)

MEC

• Increase in I reduces marginal productivity of capital asset due to

diminishing returns

• Supply price of the asset will increase due to its rising demand
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• Tobin’s q-Theory

The rate of investment in any particular type of capital can be predicted by

looking at the ratio of the capital’s market value to its replacement cost.

Firms add to their capital when q>1.

market value of corporate financial assets

q
replacement cost of corporate real assets
When q>1 acquisition cost of real assets is less than the financial cost of
acquiring them.

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• Accelerator principle

The accelerator model asserts that the investment spending is

proportional to the change in output and is not affected by the
cost of capital.

Firms maintain a stable relationship between the stock of capital

(K) and expected output (Ye),

K =  Ye , where  is the capital-output ratio.

It =  (Yt – Yt-1)

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 Determinants of Investment
• Expected output (GDP)
– Accelerator principle
• Interest rates (Monetary policy)
• Depreciation
• Corporate income tax (Fiscal policy)
• The stock market conditions
• Technological change
• Input prices
• Other business taxes

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 References
• DFS, Macroeconomics, chapter 15.

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