Investment

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Investment Saving

• Outline
• Physical versus financial capital
• Financial markets
• Theory of investment
• Investment demand
• The supply of savings
• Financial market equilibrium
• Effect of government saving
• The crowding out effect

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• Physical capital
• The tools, instruments, machines, buildings, and
  other constructions that have been produced in
  the past and that are used to produce goods and
  services.
• Financial capital
• The funds that firms use to buy and operate
  physical capital.

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Gross v. Net Investment Again

• Capital and Investment
• Gross investment
• The total amount spent on new capital goods.
• Net investment
• The change in the quantity of capitalequals
  gross investment minus depreciation.

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Stock Markets

• Stock (Equity) A certificate of ownership and
  claim to the profits of a corporation.
• Stock Market An institution that facilitates
  the transfer of stocks among wealth holders.

Examples NYSE, NASDAQ, London Stock Exchange,
Paris Bourse, Tokyo Stock Exchange, Toronto Stock
Exchange
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Bond Markets

• Bond
• A promise to pay specified sums of money on
  specified dates it is a debt for the issuer.
• Bond market
• A financial market in which bonds issued by firms
  and governments are traded.

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Firms issue new stocks or bonds to raise the
financial capital necessary to purchase new
capital goods.
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Theory of Investment
Why do firms purchase things like new offshore
drilling platforms, food processing plants, or
bulldozers? Because they expect they can make a
profit by doing so.
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Investment Function
Let

• Where
• I is gross investment
• ? is the expected profit of investment and
• r is the interest rate.

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The Investment Decision
Acquisition cost of a tractortrailer rig . . . .
. . . . 146,000.00 Useful life . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . 3
years Expected (extra) sales revenue per
yearfrom the use of the asset . . . . . . . . .
. . . . . . . . . 149,000.00 Expected costs per
year to operate the asset . . 129,000.00
Diesel fuel 37,000
Driver salary benefits 68,000 Repairs
(including tires) 19,000 Misc. (fees,
fines, etc.) 5,000 Expected net sales
revenue per year from the use of the asset . . .
. . . . . . . . . . . . . . . 20,000.00
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Computing expected profit (?)
To compute expected profit in percentage terms
Thus we have
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We would consider the tractor-trailer rig a sound
investment if the interest rate were less than
13.7 percent.
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• Investment demand
• The relationship between the quantity of
  investment demanded and the interest rate, other
  things remaining the same.
• Investment demand is shown by an investment
  demand schedule or and investment demand curve.
• As the interest rate decreases, more investment
  projects become attractive in the assessment of
  business decision-makershence, the investment
  demand function is downward-sloping with respect
  to the interest rate.

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What factors could cause the investment demand
function to shift?

• Objective influences such as the phase of the
  business cycle, technological change, and
  population growth
• Subjective influences summarized in the phrase
  animal spirits

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Why do households save?
?

1. To have a more secure future, to start a
   business, to finance a childs education, to
   satisfy miserliness, . . .
2. To earn interest.

We view interest as the reward for saving or
the reward for postponing gratification.
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The opportunity cost of spending now (measured in
lost future spending) is positively related to
the interest rate.
Value of 1,000 in 3 years at alternative
interest rates
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GOVERNMENT IN THE FINANCIAL MARKET

• Government Budget and Government Saving

GDP is the sum of consumption expenditure, C
investment, I government purchases, G and net
exports, NX. In the global economy, net exports
are zero, so for the world as a whole Y C I
G
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• GDP equals total income, which is the sum of
  consumption expenditure, saving, S, and net
  taxes, NT. So
• Y C S NT
• By combining these two ways of looking at GDP,
  you can see that
• C I G C S NT

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• Because consumption is on both sides of this
  equation, we can subtract C and simplify the
  equation to
• I G S NT
• Now subtract government purchases from both sides
  of this equation to obtain
• I S (NT G)
• This equation tells us that investment is
  financed by private saving and government saving,
  NT G.
• Government saving, NT G, is also the government
  budget surplus.

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GOVERNMENT IN THE FINANCIAL MARKET

• Total saving equals private saving plus
  government saving.
• So when the government has a budget surplus, it
  contributes toward financing investment.
• But when the government has a budget deficit, it
  competes with businesses for private saving and
  decreases the amount available for investment.

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• Effect of Government Saving
• A government budget surplus increases total
  saving supply.
• To find total saving supply, we must add the
  government budget surplus to private saving
  supply.
• An increase in saving supply brings a lower
  interest rate, which decreases the quantity of
  private saving supplied and increases the
  quantity of investment.

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