INVESTMENT DECISIONS

Prof T Prabhakar Reddy

 The Multiplier
The concept of multiplier plays an
important role in the income
determination process. This
determines how or more specifically
by what amount income increases as
the result of an increase in the level
of investment.
The multiplier or the investment income
multiplier as it is sometimes described, is
in short, the ratio of Y to Investment. The
ratio is always greater than investment.
hence, the use of the expression
multiplier.
The multiplier shows the impact of an
increase in investment on income through
the savings function and therefore,
through the consumption function.
Investment and the Rate of Interest
The decision to invest depends on
whether or not the expected rate of
return on investment is greater than
the cost of borrowing the necessary
funds; or
If the funds are already available
whether the expected returns are
higher than interest earned by
lending out the funds.
The decision to invest in a machine
for example depends upon whether
or not the investment is expected to
yield more revenue over its lifetime
than it costs to purchase and operate
(total profits)
If the rate of return is r and r is
greater than I then the machine
should be purchased even if it is
necessary to borrow the funds.
But how do we determine ‘r’?
 “r” on any investment is simply the
discount rate which exactly equates
the value of all expected future
earnings to the cost of the machine.
We say that
C=R1/(1+r)+R2/(1+r)2
As long as the MEC(r)is greater than
the rate of interest (i) or as long as
the present value of the stream of
future earnings (V) exceeds the cost
(c) investment should take place.
 Acceleration principle
National income is an important
determinant of the level of
investment. It may be more
appropriate to say that changes in
the level of income is a more direct
determinant of the level of
investment. This is stated by AP.
It=f(Ot-Ot-1)
The AP implies that output or income
must keep growing if net investment
is to be positive. If output stabilizes
even at a high level net investment
will become zero.
 The Business Cycles
There are periods of flourishing
activity leading to prosperity and
growth. There are also periods of
recession which lead to decline in
output and employment.
Usually periods of prosperity and
recession alternate in some cyclical
pattern.
Prosperity or boom is generally
followed by downswing and recession
which are in turn followed by
recovery leading to a new boom.
Such fluctuations in national income,
employment, investment and related
macro economic aggregates are
called business cycles.
 The Business Cycles
According to Keynes, “a (business)
cycle consists of expansions
occurring at about the same time in
many economic activities followed by
similarly general recessions,
contractions and revivals which
merge with the expansion phase of
the next cycle; this sequence of
change is recurring but not periodic”.
 The Business Cycles
By a cyclical movement we mean
that as the system progresses in
e.g., the upward direction, the forces
propelling it upward first gather force
and have a cumulative effect on one
another but gradually lose their
strength until at a certain point, they
tend to be replaced by forces
operating in the opposite direction
which in turn gather forces
And accentuate one another and
until they too, having reached their
maximum development, wane and
give place to their opposite. We do
not however merely mean by a
cyclical movement that upward and
downward tendencies once started
do not persist for ever in the same
direction but are ultimately reversed;
 The Business Cycles
We also mean that there is some
recognizable degree of regularity in
the time sequence and duration of
the upward and downward
movements.”
 The Business Cycles
The phases
Expansion
Peak
Recession
Trough
Expansion is characterized by a high
level of economic activity and is also
referred to as the period of
prosperity or boom. It implies a
continuous upward movement. This
comes to an end and passes into the
recession phase at the upper turning
point or peak.
During recession, production,
employment, investment, prices,
profit etc., show a continuous
downward movement till the
recession phase gives way to the
expansion phase at the lower turning
point or trough.
Thus four phases of the cycle keep
alternating themselves.
 Schumpeterian cycle
Prosperity
Recession
Depression
Recovery
 Schumpeterian cycle
In the prosperity phase employment
continues to increase but a
diminishing rate till the cycle peak is
reached. In the recession phase,
employment decreases at an
accelerating rate till point B is
reached.
 Schumpeterian cycle
After this, the cycle moves into the
lower half. In the depression phase
employment continues to fall but the
rate of fall gradually decreases till
the cycle trough is reached.
In the recovery phase employment
continues to increase at an
increasing rate till point C is reached.