Chapter 6:

THE INVESTMENT FUNCTION

Investment:
A Determinant of Income

Invesment Expenditure
- is a capital spending mainly derived not from
current income and consumption but from
accumulated savings and other sources external
to the circular flow.
- is simply assumed as an exogenous
component of National Income (i.e., external
factor affecting income)
- in reality, however, it is an endogenous
variable as income likewise affects and,
therefore, creates multiplier effect on the level of
investment.
Investment:
A Determinant of Income

Current Business Income serves current business

needs and the surplus may not suffice to finance even
a fraction of investment spending as on new
equipment. Instead, a business may borrow the savings
of the economy which households likewise do, say for
housing construction in as much as current household
income basically serves current consumption.
Investment increases the capital stock and the
expenditure for which generate income as inflows of
the system.
Investment spending, which is for long term
consumption, is not the monopoly of business since
households and government do as well.
Investment:
A Determinant of Income

For example:
in households, entertainment
derived from television viewing
everyday
in government, social overhead
facilities to provide stream of social
benefits like road facilities.
However, government investment expenditures are
classified under government spending which is
another type of income-generating inflow.
Distinction between Consumption and Investment Expenditure

Consumption Expenditure
- is spending on current consumption or
consumption of non-durable goods.
Investment Expenditure
- is spending on capital goods which are
repeatedly used and gradually consumed
over a long period as durable goods.
- it is a pre-payment of long-run
consumption.
Investment and
the Multiplier
Question:

But how does investment

spending determine
income?
Table 1 and Figure 1 will illustrate the
foregoing using the examples of y = c
= 500.
MPC = 0.80
Figure 1
Income (y) Consumption Investment C+I
(x)
0 100 80 180
100 180 80 260
200 260 80 340
300 340 80 420
400 420 80 500
500 500 80 580
600 580 80 660
700 660 80 740
800 740 80 820
900 820 80 900
1000 900 80 980
Table 1
 Thetable shows the equilibrium income is 500
assuming that consumption is its only
component because households are the only
factor contributors and personal savings is
only leakage from the system. (see Chapter 5)

However, the inclusion of investment equals to

80 increases income to 900 and the additional
income of 400 is equal to investment plus the
additional consumption it generates (I + C).
 The (C + I) line in Figure 1 includes the investment
spending as additional factor income that the system
generates equal to 80. The horizontal arrow represents
additional household consumption expenditure generating
the same additional income equal to 64 assuming an MPC
of 0.80.

Figure 1 shows that the process is complered at the point

of intersection of the Income line and the consumption
and the investment line (C + I)

Atthis point, the investment inflow has been fully

siphoned from the system as savings and nothing is left to
further generate income.
Here are the equations that
illustrate how the
investment factor is therefore:
incorporated in the income y = C + C + I
function with the multiplier y = C + I
process.

y = IM
y = I + C where:
y = income
since initially: C = Consumption
y= C I = Investment
M = Multiplier
= Change
 The equation further imply that
investment is directly proportional to
income. Figure 1 can show that an
increase in investment shifts the
consumption and investment line
upward (C + I) and generates
additional income based on the
same principle applied.
 Itshould be noted that equilibrium income
follows line y, while the corresponding
increase in consumption follows line C.

The reason why the economy does not

seem to run out of investments to at least
maintain its level of income is because
investment inflows and infinite wherein
new expenditures on time the income-
generating functions of the previous ones.
Investment and Output

Business and household

investments tend to increase the
economys stock of capital and total
output; whereas, depreciation has the
the opposite effect as it represents
capital consumption. While current
depreciation decreases total output in
the short-run, currents investment
only yields output in the long run for
two reasons.
Two reasons why current
investment only yields
output in the long run
First,
even after total investment
expenditure to meet production
targets has already been incurred,
the process of setting up and even
testing the capital base creates
operational lags.
Two reasons why current
investment only yields
output in the long run
Second, every phase in setting up a
capital base may not be capable of
independent utilization until
completion of the other phases.
Example:
Short-run investments in a
building construction

It may only provide the physical

foundation and occupancy is not
possible until the completion of the
whole structure.
Investment and the Stock Adjustment Process

Sustained investment patterns can

determine trends in the capital stock and
production level over a long period.

Capital stock is not a headcount but rather

the aggregate production capacity of existing
capital goods in the economy which can
diminish due to usage and depreciation.

Investment increases the stock since additional

capital brings additional production capacity.
 Here are the frameworks that
illustrate investment-output
relationship assuming a short-run
time frame, no investment
production time lag, and constant
capital output ratio:

Kf = (Ki + D + I)
yf = (y - yd + yi) = a (Ki - D + I)
where:
Kf = Stock of capital after depreciation and investment
Ki = Initial stock of capital, i.e., before depreciation and
investment
D = Depreciation
I = Investment
yi = Initial output from the capital stock, i.e., before
investment and depreciation
yf = Total output from the capital stock after
depreciation and investment
yd = Change in total output because of depreciation
yi = Change in total output because of investment
a = output - capital ratio (y/K)
Furthermore:
Net change in capital stock = (-D + I)
Net change in output = (-y.d + y.i)

A positive (+) net change in the capital stock

results in a positive (+) net change in output on
an increase in both the capital stock and output
the opposite is true which a negative (-) net
change in the capital stock. However, zero or
no net change means a constant level in both
the capital stock and output.
SAVINGS AS SOURCE
OF INVESTMENT
Savings

Savings is the unspent portion of

income during the period intended
for spending.
It is a residual of income which
accumulates into a stock for future
use and, therefore postpones current
consumption.
 Savingsof the economy can be simply
expressed as follows assuming that it is the
only determinant of the multiplier.

S =YC

Where:

S= Savings
Y= Income
C= Consumption
 The initial income that an investment
expenditure generates is equal to itself
Additional income comes in the form of
consumption and deducting total
consumption expenditure from total
income yields this investment inflow.
The difference is also equal to total
savings since the investment inflow is
fully siphoned from the system as
savings outflow at equilibrium income.
Savings-Investment
Equilibrium
Y =C+I
Y C = I
S = I

Assuming that income is now fully

generated, (S = I) means completing
the process of transforming the
investment inflow into savings
outflow which gradually reduces the
additional income that the system
Determinants of Savings

Pricelevel
Population growth
INVESTMENT DEMAND
DETERMINANTS
Interest Rates

Investment demand is inversely

proportional to the interest rate level
with other factors as constant
(ceteris paribus) resulting in an
investment demand curve that is
downward sloping.
The Acceleration Principle

The principle states that the level of

investments is a function of desired
changes in output. This change in
investment constitutes shift in the
investment demand curve as from
1d1 to 1d2 in Figure 41.

=(- =a
Innovations

Another long-run factor which can

shift the investment demand curve is
innovation.
Innovation can create demand for
products including capital goods and
usher the acceleration process
between income and investment.
Profit

Profitis the basic reason why a

business invests and, therefore,
profit trends influence business
investments in the long-run.
Expectations

A businessman invests and expects a

certain level of profit given a certain
influence of the business environment.
A mediocre businessman simply views the
future as a continuation of past trends.
A perspective investor delves into
underlying change to anticipate turning
points in the business environment and
decides at present the magnitude and
type of investment he should make.