Understanding

Investment
What is Investment?
As an individual for us investment means, investing in stocks, bonds, fixed deposits, and etc. In case
of macroeconomics investment is not investing in financial instruments, but in physical productive
assets. We can define investment as flow of spending by economic agents that adds to the stock of
physical capital.
In macroeconomics capital has two components, the stock of the capital, and flow of the capital. The
total stock of capital is the total value of all the buildings, machineries, inventories at a point of time.
The flow of capital is the incremental spending on different types of physical capital over a period of
time. The stock of capital is very large in comparison to the flow of capital. Therefore, a small change
in required level of stock of capital will result in large inflow (outflow) of capital.
Let us understand this with the help of an example.
Besides a river one fisherman was living. He used to fish in the river. He used to consume some of the
catch and sell the surplus in market to meet the other needs. He had a boat, a net, which was used to
catch the fishes. Some days some fishes were left unsold and unsold fishes were stored and sold the
next day.
In this example, the stock of investment is the boat, the net, and the unsold fishes.
Let us say the fisherman decides to buy another boat, another net, and employs another fisherman to
catch more fishes. He also decides to buy a refrigerator to store the unsold dishes. In this case there is
a flow of capital in the form of investment, which is a boat, a net, and a refrigerator. In the next period
this will be added to the stock of capital.

Why is it Important to Study Investment?

Investment in an economy links the present state of the economy with the future state of the economy.
Investment is also provides linkages between money/capital market and goods and services market.
Investment as a component of aggregate demand is also the most volatile component and primary
sources of economic fluctuation. Therefore, public policy that influences the investment in an
economy is a fascinating subject to study.

What are the Different Types of Investment?

In macroeconomics there are three broad types of investments. They are;

Business fixed investment: In these types of investment, producers spend on some goods and
services that help them to produce final goods and services over a period of time.
Residential Investment: These investments are in new houses. Since houses provide services
over a period of time, investment in houses are parts of investment.
Inventory investment: These are unsold finished goods and services kept in inventory for sale
in future.

What are the Factors that Affect Investment?

A producer has to make decisions about what should be an ideal investment amount for the future. To
decide the producers have to take into account many factors. Some of the important factors that affect
the investment decisions are;

Expected rate of return from the investment (Productivity of capital)

Interest rate (cost of capital)
Risk associated with the project (Uncertainty about the future)
Expected aggregate demand (External factor linked to risk)
Tax structure (Public policy)

Understanding Marginal Productivity of Capital?

Producers in an economy use factors of production to maximize profit. In this session we are
discussing the capital as factor of production, and for a producer it is important to decide how much of
capital to be used in the production process. This decision is described in theory of investment.
According to the dominant theory of investment the quantum of capital to be used will depend on the
marginal productivity of capital (MPK).
Marginal productivity of capital is the increase in output by using 1 additional unit of capital. This
additional unit of capital has a cost (price of capital), which can be visualized as rental cost (user
cost). As long as the rental cost of capital is less than the value of marginal cost of 1 additional unit of
capital, it pays to the producers to use the capital. In case the producer employs more capital the stock
of capital also increases. Therefore, in an economy the stock of capital will increase till the point the
rental cost of capital (price of capital) for an additional unit of capital is less than the value generated
by incremental capital.
The rental cost of capital can be derived by looking at the sources of funds that is used to acquire the
capital. The incremental capital can be financed either by borrowing or by selling equity shares to the
investors who are willing to invest in the capital that is being created.
Let us look at when the incremental capital is financed by borrowing money from the banking system,
at an interest rate i. This interest rate is nominal in nature. However, as an economic agent we are
interested in real values. The real interest rate (r) will have an expected component of inflation ( )
and it can visualized as

Since, the capital is expected to depreciate; the producers also need to cost the wear and tear of capital
in the cost. Therefore, we can write down the rental cost (rc) as;

A producer will desire to keep adding capital till the point the point where

The figure 3 shows the relationship between MPK and capital stock (K). The MPK is downward
sloping means, as we use more capital, the marginal productivity declines, and the stock of capital

will depend on rc. Higher the rc, lower will be the desired level of capital stock, and vice versa. The
desired levels of capital stock also depend on the total aggregate demand (Y). As the aggregate
demand increases, the desired level of capital stock also increases, and vice versa.

The desired level of capital stock can be written as;

The desired level of capital stock is inversely proportional to rc and directly proportional to Y. Public
policy that is going to reduce the rc (monetary policy, taxation benefits on depreciation, etc), and
increase Y (government spending) will positively affect the desired level of capital.

Desired Capital Stock and Investment Flow

Let us assume that the desired stock of capital is K*, and stock of capital at t-1 was Kt-1. In next period
the capital stock will depend on the gap between K* and K t-1. The adjustment process will not be
sudden, but gradual. This can be shown mathematically as;
{

The investment amount (I) is;

{

This is also known as flexible accelerator model.

Conceptually the incremental investment at the equilibrium will be equal to the depreciation of stock
of capital. However, in case there is shift in aggregate demand due to external shock, and desired
stock of capital will change. In the short-run, the price of capital will change due to increase demand
for capital, in the long-run the more investment will happen and the economy will reach the required
level of capital stock.
In case the economy has constraints to produce the required stock of capital then the economy will
operate at sub optimal level of aggregate demand.

Tobins q Theory of Investment

The producer can decide to fund the incremental capital creation by selling equity shares. This is
going to happen when the producers sees that the stock market is valuing the stock of capital more
than the replacement cost of the capital. This concept is measured by Tobins q.

If q > 1, it means the firm will find it beneficial to create more capital by selling equity. Therefore,
more investment will happen when q > 1. The reverse will happen when q < 1.