principles of economics the investment function

The Investment FunctionLULO, Michael

BSIE - III

The Investment Function

Producers in the economy must decide how much income to spend on new investment.


Producers may invest in replacing used up or obsolete machinery, expanding production, increasing raw material or finished goods inventories, and building new facilities for new products.


Each producer makes investment decisions independently of others.


Intended Investment

• Investment spending that producers intend to undertake. These intended investments do not always end up being realized.

What Determines Investment?

The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending.


Autonomous Investment

• Investment that is independent of the level of income.

EXHIBIT 6 THE INVESTMENT CURVE

Exhibit 6: The Investment Curve

How does the investment curve (I) in Exhibit 6 change as the level of national income changes?• The investment curve does not change. It remains at $75 billion at every level of national income.


Four factors determine the size of the economy’s autonomous investment.1. Technology Level

2. Interest Rate

3. Expectations of Future Economic Growth

4. Rate of Capacity Utilization


1. Technology level

• The introduction of new technologies is one of the mainsprings of investment. Technological leaps produce extensive networks of investment spending.


2. Interest rate

• Producers undertake investment when they believe the rate of return generated by the investment will exceed the interest rate, that is, the cost of borrowing investment funds.


2. Interest rate

• There is an inverse relationship between the rate of interest and the quantity of investment spending.

EXHIBIT 7 THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT

Exhibit 7: The Effect of Changes in the Rate of Interest on the Level of Investment

Why is the demand curve for investment in panel a of Exhibit 7 downward sloping?

• The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.


3. Expectations of future economic growth

• Investment spending reflects how producers view the future. Future expectations are shaped by past performance.


4. Rate of capacity utilization

• Producers seldom choose to operate at 100 percent capacity. Operating at less than 100 percent capacity gives them the ability to expand production on demand.


• How much flexibility producers end up choosing influences the economy’s level of production. For producers who choose to operate close to full capacity, a moderate increase in sales may shift them quickly into investment spending.

4. Rate of capacity utilization


The level of investment spending in the U.S. economy is volatile. Sometimes the factors that effect investment spending pull in opposite directions. Other times, they work in unison and lead to impressive economic growth.

EXHIBIT 8 THE VOLATILITY OF INVESTMENT

Unlike consumption, which is fairly stable over time, investment is subject to erratic fluctuations even through very short periods of time. The economic and technological factors that influence investment can sometimes create the conditions for rapid expansion of investment and, just as quickly, reverse to cause investment to fall just as rapidly, as we see in the annual rate of change in real investment spending over the years 1960 to 1995.Source: Economic Report of the President 2006 (Washington, D.C.: United States Government Printing Office, 2006), p. 285.

Exhibit 8: The Volatility of Investment

How does the rate of investment spending in Exhibit 8 compare to the rate of consumption spending?

• While the rate of consumption spending is fairly stable over time, the rate of investment spending is volatile.

principles of economics the investment function

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