Introduction Theoretical Theories Of Investment Economics Essay

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Investment is a strategic variable in the determination of the level and growth of income. It has been defined in various ways by various economists. Generally, it refers to any act of spending with a prospective yield. To the economist, it refers precisely to the process of capital formation whereby there is net addition to the existing assets including inventories and goods in the pipeline of production. It is the actual production of capital equipment, tools and other produced means of production. Investment might be capital formation: Financial Capital and Physical or real capital. There are gross, net and autonomous investments where:

Gross Investment= Net Investment + Autonomous Investment

Autonomous Investment also known as Government Investment refers to investment which remains the same whatever the level of income. It refers mainly to the investment made on houses, roads, public buildings and other parts of Infrastructure made by the government.

Moreover Gross investment is the amount that a company has invested on an asset or business without taking factoring in depreciation into consideration. In other words it is the total amount of money spent for the creation of new capital assets like Plant and Machinery, Factory Building etc. It is the total expenditure made on new capital assets in a period.

Furthermore in economics, Net Investment refers to an activity of spending which will cause an increase in the availability of fixed capital goods or means of production. It is the total spending on new fixed investment minus replacement investment, which simply replaces depreciated capital goods. In fact it is Gross investment less Capital Consumption during a period of time.

Private Investment depends on various categories of variables. So various theories of investment have been presented and they are provided overleaf:-

Fisher Theory of Investment

This theory was developed in 1930. Fisher’s theory was originally developed as a theory of capital, but as he assumes that all capital is circulating, then it is just as proper to conceive of it as a theory of investment. It was provided by Fisher that during the production process, all capital is used up, such that a ‘stock’ of capital K did not exist. In fact all capital is just investment.

There was a condition imposed by Fisher stating that Investment in any given period of time will yield outputs in the nest period. This is illustrated through the equation below:

Y2=F [N,I1]

Y2 = Output in period 2

I1 = Investment done in period 1

N = labor

Assuming a world with only two periods of time, t=1, 2. Investment done in period 1 yields output in period 2. Moreover Fisher assumes that labor is constant

Keynesian Theory

The Keynesian theory was developed after that John Maynard Keynes (1936) followed suit of the Fisher theory. Keynes stated that there is an independent investment function in the economy. An important aspect of the Keynesian theory is that although savings and investment must be identical, ex-post savings and investment decisions are made by different decision makers and there is reason why ex-ante savings should equal ex-ante investment. According to Trygve Haavelmo (1960) “The “Keynesian” approach places far less emphasis on the “adjustment” nature of investment. Instead, they tend to have a more “behavioral” take on the investment decision. Namely, the Keynesian approach argues that investment is simply what capitalists “do”. Every period, workers consume and capitalists “invest” as a matter of course. They believe that the main decision is the investment decision; the capital stock just “follows” from the investment patterns rather than being an important thing that needs to be “optimally” decided

Accelerator Principle Theory

Over the past two decades, the acceleration principle has played a vital role in the theory of Investment. In fact, this theory was developed before the Keynesian theory; however it became apparent after Keynes’ investment theory in the twentieth century. The accelerator is generally associated with the name of J.M Clark though it seems to have been first developed by the French economist Albert Aftalion. The basis of the accelerator principle is based on the fact that changes in factors affecting national income would affect investment. In other words, big percentages changes are witnessed due to small in consumer spending. This type of investment is known as induced investment since; it is induced by changes in consumption and income. Furthermore, the accelerator is just the numerical value of the relationship between the increases in investment caused by an increase in income. Normally, it will be positive when national income increases. On the other hand, it might fall to zero if the national output or income remains costant.

Neo-Classical Theory

In 1971, the neoclassical approach which is a version of the flexible accelerator model was formulated by Jorgenson and others. Flexible Accelerator Model is a more general form of the accelerator model. It is assumed that firms will choose only a fraction, ‘a’, of the gap between desired and current actual level of capital stock each period. The larger the gap between the desired capital stock and the actual capital stock, the greater a firm’s rate of investment. This is illustrated below:

I = a [K* -K-1]

I = planned net investment during period t

K* = desired level of capital stock

K-1 = current actual level of capital stock at beginning of period t (end of period t-1)

a = adjustment factor, 0 < a < 1

The desired capital stock is proportional to output and the investor’s cost of capital which in turn depends on the price of capital goods, the real rate of interest, the rate of depreciation and the tax structure. It is important to note that most recent empirical works are based on Jorgenson investment function. In fact Jorgenson provides that a decrease in interest rate would cause an increase in investment by reducing the cost of capital.

In 1967, Hall and Jorgenson provide the Hall Jorgenson Model of Investment. The model illustrates that the level of capital stock that is chosen by an optimizing firm depend on various economic features like the production function, depreciation rates, taxes, interest rates. In fact Hall and Jorgenson had used the neoclassical theory of optimal capital accumulation to analyze the relationship between tax policy and investment expenditures. They concluded that ” tax policy is very effective in changing the level and timing on Investment expenditures.”

“Q” theory of Investment

The “Q” theory of Investment, introduced by Tobin (1969) is a popularly accepted theory of real investment. In fact it is a basic tool used for financial market analysis.It is a positive function of ‘Q’which can be defined as the ratio of the market value of the existing capital to the replacement cost of capital. “Q” can be defined as follows:

Q=Stock Value of Firm/Replacement cost of Investment

“Q” is a barometer for investors as it tends to assess a firm’s prospect. When “Q” is greater than one, the firm would make additional investment because the profits generated would be greater than the cost of firm’s assets. If “Q” is less than one, the firm would be better off selling its assets instead of trying to put them to use as the firm’s value is less than what it cost to reproduce their capital. The ideal state is where “Q” is approximately equal to one denoting that the firm is in equilibrium.

The “Q” theory of investment can also depend on adjustment cost. Literature on this issue was done by Eisner and Strotz (1963), Lucas (1967), Gould (19678) and Tredway (1969). Later Mussa (1977), Abel (1979, 1982) and Yoshikawa (1980) showed that Investment is an increasing function of the shadow price of installed capital. This is such only when there are convex adjustment costs.

“Marginal Q” Model of Investment

Moreover Abel (1981) and Hayaski (1982) introduced the ‘marginal q’ model associated with smooth convex costs of adjustments. They assume that capital market are perfect, such that investment is undertake until the marginal value of an additional unit of investment has decreased to the exact value of the riskless interest rate. Abel (1981) describes marginal q as “The optimal rate of Investment is an increasing function of the slope of the value function with respect to the capital stock (marginal q).” Abe; states that an increase in any factors that affect price can cause an increase, a decrease or even do not affect investment rate. The effect will depend on the covariance sign of the price with a weighted average of all prices. Hayaski (1982) provides that under linear homogeneity, marginal q is equal to average q. However when marginal q is not equal to average q, it is marginal q which is relevant for investment. In fact marginal q is just a stochastic version of the ‘Q theory’ of Investment.

Neo-Classical theory and “Q” theory of Investment (Panageas 2005)

According to Stravos Panageas (2005), the neoclassical theory provides that Investment and the stock market are linked through the Tobin ‘q’. This is because the net present value of the company is the value of the company, so when the stock market is rising, there should be an increase in Investment to equate the Q ratio. This involves speculation. Panageas (2005) states that “If firms maximizes share prices, then Investment reacts to speculate overpricing.” However he also provides that when investment is controlled by shareholders, who do not have perfect access to the market, the link between investment and speculation will not hold. There might be costs to access the market like capital gains taxes, price pressure etc. The model used by Panageas also aid to distinguish between rational and behavioural theories of asset pricing ‘anomalies’.

Models associated with non-convex costs

There are also models with Non-convex costs of adjustments. King and Thomas (2006) states “Non-convex adjustment costs imply distributed lags in aggregate series similar to those

generated by convex costs, because they stagger the lumpy adjustments undertaken by individual

firms in response to shocks”. These non- convex costs is linked with the investment theory. A number of influential partial equilibrium studies (Caballero and Engel, 1999; Cooper,

Haltiwanger and Power, 1999; Caballero, Engel and Haltiwanger, 1995) have showed that these investments models cause great changes in investment demand following large aggregate shocks.

Theories of Interest Rate

There is a vast spectrum of interest rate at a given period of time in a country. The interest rate will depend on several variables such as nature of loans, duration of loans, credit worthiness of borrower, hire purchase agreements. When those variables are held constant, the rate of interest or pure interest rate is obtained. The most common theories used to explain interest rate determinations are the Loanable Funds Theory (Neo Classical) and the Liquidity Preference Theory (Keynesian Theory). Furthermore the ISLM model is held for a fully integrated approach.

Loanable Funds Theory/ Neo Classical Theory

We will first consider the Loanable funds theory which is also known as the neo classical theory of interest. It was developed by the Swedish economist Knot Wickshell (1851-1926). The rate of interest is obtained through the demand and supply of loans in the credit market. The demand for loan is mainly to invest, to consume and to hoard. Traditionally the demand curve will slope downward because a fall in interest rate will attract borrowings. The supply of loans comes from 4 important sources. These are saving, bank money, dishoarding and disinvestment. The supply curve will be upward sloping since a higher rate of interest will induce these sources to supply more loans. So according to the Loanable funds theory, the rate of interest will be determined where these two curves intersect. This is shown below:

Rate of interest





Figure 1.1

Loanable Funds

According to figure 1.1, the equilibrium rate will be R1 and Q1 will be the amount of loan that are demanded and supplied. Interest rate either above or below the equilibrium rate will be restored to the equilibrium rate through upward and downward pressure. Changes in the demand and supply of loan will alter interest rate. For example, technological changes might increase the demand for loanable funds. So according to this theory, the rate of interest is the price that equate the demand for and the supply of loanable funds.

Liquidity Preference Theory/Keynesian Theory

The Liquidity Preference Theory was developed by Keynes. Keynes described interest rate as a purely monetary phenomenon which is determined by the demand and supply of money. Keynes identified 3 reasons why people would prefer liquidity rather that assets. These are:

Transactions demand for money

The transaction demand is the demand to hold money in order to meet day to day transactions. The amount of cash which the individual will keep in his possession will depend on his size of his personal income and the length of time between his pay days.

Precautionary demand for money

The precautionary demand is the demand to hold money in order to meet unforeseen events such as illness, being unemployed. The amount of money that the individual will hold for precautionary motives will depend on the individual’s condition, economic and political conditions which he lives. The size of his income, nature of the person and foresightedness will also affects the precautionary motives of a person.

Speculative demand for money

Speculative demand is the demand to hold money as oppose to the holding of bonds. There is an inverse relationship between bonds and the rate of interest. When the price of bond tends to rise, rate of interest will fall due to the inverse relationship, so people will be buying bonds to sell them later when the price actually rises. However when bond prices are expected to fall leading to a rise in the rate of interest, people will sell bonds to avoid losses. According to Keynes, when the interest rate is high, speculative demand for money will be low and vice versa.

The supply of money is the amount of money in circulation at a specified time period. It is the central bank which will be determining the supply of money. It is fixed at any given period of time. According to the Liquidity Preference theory, the rate of interest is determined where these two curves intersect as illustrated below:


Liquidity Preference (LP)

Quantity of money




Rate of Interest



Figure 1.2

As illustrated by figure 1.2, the money supply is represented by S1Q1 along the LP function. The rate of interest will be R1 where the supply of money intersects the LP function. If there is an increase in the money supply to S2Q2, there will be an excess in the supply of money causing people to adjust their demand portfolio by purchasing bonds. The price of bonds will rise leading to a fall in interest rate to R2.

Investment/Saving-Liquidity Preference/Money supply (IS-LM) Model

The previous two theories does not take into consideration in changes in national income to affect the rate of interest. The IS-LM model is used to arrive at a determinate solution. In fact it is part of the Keynesian theory. In the IS-LM model, interest rate is the only determinant of investment. The IS-LM model assumes that a higher interest rate will result in lower investment and vice versa. In this model interest rate will change due to changes in factors like business activity, credit creation by a bank, confidence, the level of national debt, inflows of funds and even international forces. Keynes provided the investment schedule where interest rate is the only primary determinant of investment. The schedule shows the amount of investment that firms would carry out at each rate of interest.

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