IV Investment

12. From the theory of capital to the theory of investment.

12.1 Concept of investment in Economics

The action of investing consists of acquiring, manufacturing, or constructing goods that will be used for production.
other goods. Therefore, with this action, the entrepreneurs do not intend to satisfy a need
of consumption, but they expect that the result of the investment will yield income in the future
superior, which will serve to satisfy their consumption needs at that future moment or
to increase their wealth. Therefore, investment is the expenditure dedicated to increasing or maintaining
the capital stock.

Investment goods are usually differentiated into three basic categories:

• inventories (working capital)
• machinery and equipment (fixed capital) and
• housing and infrastructure (social capital).

The stock of capital includes the collection of factories, machinery, equipment, offices, housing,
goods in stock and all other durable goods used in the production process.
Investment is the spending that grows the components of the capital stock.

Feed the stock formation

Variable Capital Inversión Variable

Stock Flow

It influences investment decisions

Within the Fundamental Macroeconomic Equation, the component designated as Investment

it refers to private investment and its more precise designation is Gross Domestic Investment.
it is composed as follows:

Investment Gross Fixed Investment Variation of

=
Gross Internal Inventories IBI = IBF And

Investment Net Fixed Investment + Investment of

= IBF = INF + IR
Fixed Gross Restoration

Variation of Inventory at the End of the Period -

= Ve = EF - EI
Stock Inventory at the beginning of the period

12.2 Alternative Investment Concepts

According to the capital replacement

Gross Investment. It is the investment that includes both new investment and investment
for replenishment (intended to keep the existing stock usable against the effects of
use and the breakage, obsolescence, and the possible destruction or loss of its capacity
productive). It is always positive.
Net Investment. It is the effective addition to the existing capital stock. Net Investment
Fix corresponds to any level of investment that exceeds the replacement level. It can, by
so much, to be negative.
Replacement investment. It is the expense incurred in the necessary replacement, to
compensate for the wear and tear of capital goods.

According to the composition of capital

Fixed capital. It corresponds to the investment in plant and equipment, all the manufacturing or
acquisition of goods (new) for the manufacture of goods: factories, roads,
tools, infrastructure in general, machinery, etc.
Social capital. It corresponds to residential construction, or housing for
to inhabit.
2 Macroeconomics I

Working capital. It refers exclusively to the variation of inventories, or difference.

between existence at the end and at the beginning of each period. This is included as an investment, for
it refers to goods produced and not consumed or invested in the period. That is, the
stock of finished or in-process products (whether for consumption or investment) that do not
have been sold at the end of the period. In the final expense stream, the
purchases of goods for consumption and/or investment, so that including the variation of
existences reaches the concept of final goods production, that is, GDP. From what
On the contrary, only the sold ones would be counted, not those produced that have remained unsold.
to sell.

According to the geographical generation of the investment

Internal Investment. It is the investment made within the country's borders.
National Investment. It is carried out by the residents of a country.

According to the investment planning

Planned investment is the one that adjusts to the investment forecasts of the
entrepreneurs for a certain period. It can be equal to, greater than, or less than the savings.
planned.
Actual Investment. It takes into account those consumer or investment goods that
have not been sold by the end of the period and remain in stock (investment in
unwanted inventory). It is always equal to the savings made.

According to the origin or motivation of the investment

Autonomous Investment. That level of investment which is independent of the level of
production and income.
Induced Investment. That which depends on the level of variations in the level of
Income (production) or the interest rate (i).

12.3 Determinants of Investment

The interest rate (i). If companies need to borrow funds to acquire the
investment goods that they use, the higher the interest rate, these will have to pay
every year, as interest, a larger fraction of the profits they obtain from their
investment; therefore the higher the interest rate, the less profit it has
company after paying the interests and lesser will be its desires to invest.
Eventually, the interests could outweigh the benefits, inhibiting the entrepreneur from
to perform the act of investing. On the contrary, a low interest rate makes spending
Investment is beneficial and is reflected in a high level of planned or desired investment.
This is equally valid in the case where the businessman has the funds to
invest, since in that case the expected benefits of the investment must be
higher than the alternative profitability that the entrepreneur would obtain through a
financial placement (opportunity cost).
The existing stock of capital. While the classics assumed that prices and wages
They were flexible and that full employment equilibrium would always be achieved, the thought
Keynesian introduced the concept of 'unplanned investment' (stocks or inventories without
to sell), that is to say, an equilibrium is reached although not precisely full employment.
Expectations. The objective of a company is to obtain profits. Therefore, when
When considering the possibility of purchasing a new investment asset, the entrepreneur must
to wonder how many benefits this will generate during its productive life. If the value
the actual succession of expected benefits is greater than the acquisition cost and the
installation of the machine, the company will take the step to invest. Otherwise, it will not.
In reality, the investment depends on the uncertain and fluctuating nature of events.
Therefore, the investment fluctuates because the present knowledge of the future is generally
precarious and the decisions concerning the future are also precarious. The entrepreneurs,
Not having certainty about future events, they protect themselves with a behavior.
cautious. In summary, investment fluctuates due to those mismatches between planned savings and
the ex post or actual investment. Therefore, it is possible to achieve equilibrium with unemployment. It is
to say, that if the expectations of future benefits are uncertain, the behavior
colectivo lleva a un resultado “subóptimo”. Los desajustes entre ahorro e inversión estarían
provoked by changes in investor expectations. Investment is being made to
it ends when the expectations of benefits exceed the cost that must be paid for it
money borrowed, or in other words, the interest rate.
It can be concluded that investment -and therefore the level of employment- depends on that the
expectations of future returns are higher than the interest rate. When it falls
confidence in the future and the profit forecasts are not favorable, the cost that there is
what to pay the holders of money to part with it will exceed the rate
Macroeconomics I 3

expected performance. In this case, the investment will be lower and the employment level will fall.
By decreasing investment, a recessionary cycle will occur.
Accumulated business benefits. Self-financing is an important
source of financing for investments, especially in times of expensive bank credit or
scant
Prices. According to this interpretation, companies invest according to the
evolution of the prices of their products, especially if they increase more than prices
of the economy.
The growth rate of national product. According to the Accelerator model
Simply put, as will be seen later, the investment expenditure is proportional to the variation of the
production. According to this, companies invest only if they expect production
increase.
Other subjective variables (tastes, trends, etc.)

In our initial model, we will limit ourselves to the stocks, since in the short term it is not
it is possible to modify the production plants, the equipment or the homes.

13. Autonomous and induced investment

We are going to consider, until we study money and the market of goods together, that the
investment in inventories is determined exogenously; that is to say, that in the current state of
the economy, business owners wish to have a quantity in their company's warehouses of
goodsIo.

The inventory level Iodepends on exogenous variables of the model, so the line of
investment is horizontal and parallel to the x-axis which indicates that the demand for investment
it is the same regardless of the income level. This is known as autonomous investment, it is
to say, (just as it is considered in the basic Keynesian model).

Investment

a
I0

Y1 Y2 Y

Autonomous investment

In Figure 8, it can be seen that the investment is made independently of the level of product or
income. The investment variable is considered exogenous. For any level of income, investment
remains in Io.

Later we will see that investment depends on other variables, such as the level of
Income (Y) and the interest rate (i). We know this type of investment as Induced Investment.
I= f bi,Y c

In the following figure, in the drawing on the left, the inversion is an increasing function of
income. Higher levels of income are compatible with higher levels of investment. They
consider in this example that there is also some autonomous investment. In the drawing of the
On the right, an induced inversion by the interest rate (i) is observed. The line shows for each
interest rate, how much companies plan to invest. The functional relationship is indirect. If (i) is
high, so the investment is low.
4 Macroeconomics I

Investment

i2
I I
I2
I1 i1

Y1 Y2 Y I2 I1 I
Product Investment

Possible models of induced investment

13.1. Elasticity of Investment Demand

The elasticity of investment can be established based on the interest rate. That is,
how much the demand for investment changes in response to a change in the interest rate. This
It will depend on the slope of the investment line.

i i
ELASTIC INELASTIC

I I

Elasticity of investment demand

In the left graph of figure 10, in response to a small decrease in the rate of
interest, investment varies greatly (elastic). In the graph on the right,
decrease in the interest rate does not encourage investment much (inelastic).

We define the interest elasticity of investment as:

ffffffffIf do
ε I=
of I
Thus, a flexible investment will reflect a high reaction of investment demand in response to
small changes in the interest rate; while an inelastic investment reflects a decrease
reaction of the investment, even in the face of significant changes in the interest rate.

14. Role of investment in the production system

Businessmen maintain a stock of goods to meet consumer demand. If

this increases unexpectedly and they do not have enough stock, entrepreneurs will see that
their stock levels fall below the desired level, so when addressing the demand for
consumption will induce increases in production by placing new orders. When they see empty their
stocks, they are investing in inventories less than they want. That is, the desired investment
it is higher than the actual investment, and since they want to reach the desired level, they activate the process
productive with new orders of goods.

On the contrary, if consumption falls, more goods accumulate in stock than entrepreneurs
they want. The desired investment is lower than the actual investment and they will give the order for the orders of
goods in progress are not fulfilled, halting the production process. This is the mechanism by
which adjusts the market of goods and services and explains why the level of stocks is a
important indicator to understand the situational context of a country.
Macroeconomics I 5

Production Consumption Investment Total Expense Imbalance between Variation Trend

or Rent Planned Planned Planned Production and Expenditure undesired of resulting in
Y C I DA = C + I Y - DA stocks the production
2600 2880 200 3080 -480 decrease expansion
3000 2800 200 3000 0 they do not vary balance
4500 4000 200 4200 300 increase contraction

At this level of analysis, we assume that the work is fully employed and, in
As a consequence, the product is also at its full employment level. Therefore, the
fluctuations in the product come solely from changes in capital stock or
of other supply-side shocks on the production function, but not of movements in
aggregate demand.

15. Autonomous Investment: the Multiplier in the Keynesian Model

We know the behavior of families regarding consumption demand and we assume

a stable behavior of entrepreneurs to determine their investment desires, because
which we can know the level of income and production to which the economy tends, that
we call it the breakeven point.
C + S = Y = DG = C + I
So we are also in balance if:
S=I
C+ I
OG=DG (45°)
C
Consume Point of
balance

C0+ I0

C0

Y0 Producto(Y)

S
Point of
Savings balance
I =S
Ii0
I

Y0 Product(Y)
- C0

Global supply and demand equilibrium / equilibrium of savings and investment

These conditions are analyzed in chart 11. The sum of consumption and investment (in this case
autonomous), is the Aggregate Demand, which is represented as an upward-sloping line. The condition
Equilibrium in the goods market occurs at the point of intersection of Demand
Aggregated, with the 45° line, where it is equal to production and income. The level of
rent and production Y0it is the level that the goods and services market tends to and marks the
production of the country and its income (National Income or Net National Product at factor cost). The
The bottom part of the graph shows another aspect of equilibrium in the goods market. The
stability is achieved when savings match the planned investment by the
entrepreneurs.

15.1 The Adjustment Process

If the level of production and income of the economy is below the equilibrium level (Yo), the supply of
goods is less than the demand. Since the demand is greater than production, the public, in its
Desire to acquire goods depletes the desired level of stocks for entrepreneurs. The investment.
effective is less than the desired investment. Entrepreneurs request that they be served new
6 Macroeconomics I

orders and the production sector gets started (remember that companies are price
accepting). As production increases, the difference between supply and the
demand decreases until reaching Y0.

If production were greater than equilibrium, demand would be insufficient and there would be an excess of
goods. Business inventories would accumulate above the desired levels and would
they would reduce orders, beginning a decrease in production until it matched with
the demand. In this model, it is observed that production adjusts to demand.

15.2 The Multiplier Effect

If we start from an initial demand DG that determines an equilibrium rent and a surplus is produced
an increase in autonomous investment, the equilibrium income rises to YeThe process of
the adjustment is simple. For the income level Ye, once the demand shifts to DG', there is
an excess of demand. Stocks decrease and entrepreneurs request new orders,
increasing production up to the new equilibrium income level.

But we observe in graph 11 that the increase in production and income is much greater than
the initial demand increase (rise in autonomous investment). If the economy is in
recession and we can act on some component of demand, there will be an increase
more than proportional to the production, which will allow us to exit this recession.

The initial increase in Investment raises the AD by the same amount. This initial pull of
the demand initiates a process of adjustment that, after increasing production, causes a rise in the
rent. When rent increases, savings and consumption rise (in the proportion indicated by the
PMgC); and let's remember that Consumption is a component of DA, so spending will increase.
again. This rise in the DA (now induced) generates a new adjustment process that
temporarily ends with a new increase in production; in turn, the rise of the
rental raises savings again and consumption once more, and the process continues.

This process stops according to the importance of the outputs that diminish the multiplier effect.
this is, that part of the income that goes to savings. If a lot is saved, the multiplier effect
disappears quickly, while with a high PMgC, that effect reinforces itself. The
multiplier, operates in both directions. If investment falls, it drags down production a lot.
beyond the decrease in aggregate demand, the recession is greater.

16. The investment induced by income: the Principle of Acceleration

How much capital would companies wish to maintain, given the costs and the returns?
derived from its use and the level of production they expect to obtain? This is what they
denotes the Desired Capital Stock (K*) that companies would like to have in the long term,
without considering the delays they have to face to obtain it. Throughout the
time, from its current capital stock K0 up to the desired level K*, the adjustment rate
determine how much companies will spend in each period to increase their capital stock, or
So, what will be the investment made in each period.

The existing capital stock will generally be different from the capital stock that companies desire.
to have. There are reasons why companies in general do not attempt or cannot achieve
immediately your desired capital stock. In any case, taking into account the different
business structures, the situational context that will determine the Cost of Utilization of
Capital and the profile of different entrepreneurs, the options to move from the current endowment of
the desired stock capital is two:
• Instant adjustment. It involves making the necessary investment within a period to obtain
the desired capital.
• Gradual adjustment. Business adjusts capital stock through successive doses.
investment in various periods, until adjusting to the desired capital.

16.1 Instantaneous Adjustment or Simple Accelerator Hypothesis

The Instantaneous Adjustment is explained by the 'Simple Accelerator Hypothesis'. The simple model
The Accelerator is based on the idea that companies install new capital when they need it.
produce more. In this way, the investment expenditure is proportional to the variation of the
production, and it does not depend on the cost of using capital. Therefore, companies invest only if
they expect production to increase. The limitation of this model is that it disregards what
the cost of capital utilization.
Macroeconomics I 7

K= vY
I t= Kt@Kt@ 1= vYt@Y
b t@ 1I t =cv∆Y
It is interpreted as 'v' being the coefficient 'Capital / Product', or a simple accelerator of investment.

Based on what has been seen so far, the determinants of Investment can be classified into factors.
what determines the desired capital stock by entrepreneurs and the speed at which they seek it
accumulate the desired stock. Many authors have placed special importance on the so-called
acceleration principle as an explanation, in this context, of investment behavior.
Let's assume that for the manufacturing of footwear, the technological and engineering requirements
they require having $200 million in equipment capital for every $100 million in value
footwear produced and sold (v = 2). We assume constant prices and that monetary values
they coincide with the real ones; that is to say, that the relationship between product and capital investment is physical,
but it is expressed for convenience in currency.

We will also assume:

• that the installed equipment has a uniform lifespan of 20 years;
• that the footwear manufacturing sector sells shoes at the beginning for a value of $100
millions a year, and has an invested capital of $200 million;
• that the age distribution of its capital is such that, in the course of the next 20
For years, it will spend (amortize) one-twentieth annually, that is, $10 million.
• that the behavior of sales is supposed to be known and predictable.

Capital Capital Investment of Investment Investment

Year Sales Desired Existing Replacement Net brutal
2001 100 200 200 10 - 10
2002 110 220 200 10 20 30
2003 125 250 220 10 30 40
2004 135 270 250 10 10 20
2005 140 280 270 10 10 20
2006 140 280 280 10 - 10
2007 135 270 280 - - -
2008 125 250 270 - - -
2009 115 230 260 - - -
2010 100 200 250 - - -
2011 95 190 240 - - -
2012 95 190 230 - - -
2013 100 200 220 - - -
2014 115 230 210 10 20 30
Instant adjustment

In the initial year (2001), it is sold for $100 million, and the capital stock is $200 million.
Consequently, the stock of equipment is exactly sufficient to carry out the production.
essential to meet the demand; therefore, the sector acquires $10M in equipment to
to compensate for depreciation, but it does not increase its stock of equipment. Consequently, the investment
The replacement cost is $10 million, the net is zero, and the gross is $10 million. It is observed that the
variations in shoe demand have a magnified effect on the demand for
equipment to produce shoes.

In 2002, shoe sales are expected to rise to $110 million. To produce that amount
For footwear, it is necessary to have $220 million in equipment; therefore, in addition to replenishing the $10
The company spends $20 million on machinery throughout the year to purchase other equipment.
getting the capital stock to the desired level. Then, the replacement investment is
of $10 million, the net is $20 million and the gross is $30 million. The result is that 10% of
Increase in shoe sales determines a tripling of gross investment in equipment.
It is easy to notice that the magnification will be greater the longer the life of the
team.

It should also be noted that investment in equipment depends on the absolute variation rate of
the sales of the final product. In 2004, sales continue to increase, but at a slower rate.
that in the previous period, a situation sufficient to cause a decrease in investment
gross from $40M to $30M. How (due to the acceleration principle) the investment decreases so
pronto como disminuye la tasa de aumento de las ventas,los puntos críticos de la inversión
precede the critical points of sales.
8 Macroeconomics I

The effects of the acceleration principle are not symmetrical between periods of increase and periods of decrease.
of a decrease in final demand. Starting in 2006, there is a period of decline in sales that
lasts until 2011. The adjustment of the equipment stock to the decreasing production rate is
limited, however, by the fact that the stock of equipment cannot decrease any faster
that the wear of the machines. Therefore, during several consecutive periods (despite
some small increases in sales), no investment of any kind is made.

Just in the last period, due to a significant increase in sales to $115 million, along with the
continued wear of the existing equipment, a reappearance of demand is observed in that year
investments of $30 million.

16.2. Gradual Adjustment or Flexible Accelerator Hypothesis

The Gradual Adjustment is explained by the Flexible Accelerator hypothesis, in its approach.
neoclassical. To determine how much capital companies would like to use based on their
cost of use, of the returns derived from its use and the level of production that
they hope to obtain, we analyze the concept of Desired Capital.

As explained earlier, the Desired Capital Stock (K*) is the stock of capital that the
companies would like to have in the long term, without considering the time it takes (delays) in
adjust the use of capital. However, it is necessary to analyze how long it takes for the
companies in requesting new machines, building factories and installing the machinery to know the
the rhythm in which capital is incorporated over time within the adjustment process between the
the stock of real capital and the stock of desired capital. The adjustment rate determines how much they spend
companies every period to increase their capital stock.

Desired Capital Stock

It is a neoclassical production function of the Cobb-Douglas type.1:

Y= Kγ AL1@ γ
where:
Y = level of production
K = amount of capital used in production
L = amount of work used in production
γ coefficient of capital participation in total income
el Stock Deseado de Capital (K*) es función delcosto de usodel mismo y del nivel de producción,
according to the following equation:

fffCfffffγY
fffffffffffffffffffffffffffffK= f γY
with
t i @π + δ

The previous equation expresses that the Desired Stock of Capital depends on the cost of use and the
production level. K* is greater the lower the cost of capital use and the greater
it is the level of production.

As a first approach to the concept of cost of capital use (cu), we identify it as

with the market interest rate, considering that companies have to go into debt to
financing its use of capital. If a company has incorporated capital in a period, it is
It is possible that at the end of it, he still has a large part of that capital, which will be used.
in the subsequent periods. But surely, this capital has depreciated throughout the year.
and the company will incur expenses to maintain its productive efficiency. Taking into account
that the real interest rate is the nominal interest rate minus the inflation rate, we can
incorporate this concept into the cost of use formula:
with= r+ δ i@π t +δ
The basic notion on which this hypothesis is based is that the greater the gap between the stock
The greater the gap between existing capital and desired stock, the higher the pace of investment by the company.
the hypothesis is that companies plan to cover, in each period, a fractionλ from the gap

1
The Cobb-Douglas function, commonly used in Microeconomics, is characterized by its homogeneity of degree one.
regarding the factors of production, which implies that:
Y= f b K,Lc ; λY= fλK,λL
b c
 Macroeconomics I 9

between their desired and existing capital stocks. Let's call it K.t-1existing capital stock
end of the last period. The gap between the desired capital stock and the existing one is:
C
K@K t@1
The company plans to add to the capital stock, Kt- , a fractionλ1from the gap, in such a way that
the stock of capitalK, at the end of the current period, will be:
C
K t = K t@ 1+ λ K@K
b t@1 c

Therefore, the net investment for the period that the company must make to cover a
portionλ of the gap, it is:
C
I t = λ K@K
b t@ 1 c
what constitutes the formulation of the gradual adjustment of net investment. In this equation, it
Note that the current investment is greater the larger the gap between the stocks of
desired and existing capital. With a zero gap, net investment is zero.

16.3. Difference between the Multiplier and the Accelerator of Investment

As we saw, it is called the Accelerator Principle of Investment, the relationship existing between the
growth rate of the product and the level of investment. It tells us that investment
expands with an increase in the growth rate of the product. If there is no variation in the
production does not lead to an increase in investment. This concept is different from the concept
of the multiplier, which implies that in the face of an exogenous variation in investment demand, it
produce a variation in income.

The Accelerator proposes that if there is an increase in demand due to a policy measure
implemented by the government, for example, it may happen that temporarily it exceeds the
desired level of growth. This is due to the fact that this increase in demand causes the
investment will grow at a faster pace. Then, investment will decrease to its growth level.
normal.

17. Project evaluation criteria

17.1. Net Present Value (NPV)

In this method, the costs of the benefits occurring in each period are subtracted to obtain
a flow of net benefits. Then this flow is updated using the discount rate and is
Obtain a net present value. If this present value is positive, the project should be accepted.
and if it is negative, the project will be rejected. If different alternatives are being compared, it ...
will opt for the one that has a higher present value (as long as it is positive). The
the general formula is:
fffffffffffffffffffffffffffffffffffffffffffffffffffVAN=
ffffffffffff R R1 ffR
ffffffffffffffffffffffR Rt B@C
+ …+ fffffffff=fffPffffff ffffffffff=fffPffffff
n t
+ 1
+
` 1+ ia0
0
` 1+ i a1+ i`
2
a2 ` 1+ I an ` 1+ I at ` 1+ i att

In this description of the method, the initial investment price is included as a cash flow.
negative, which appears to be subtracted in the overall sum. Hence, the criterion for whether to accept or not
an investment project, as long as the NPV is positive. The magnitude of the NPV is in units
monetary.

Another alternative for using this method is not to include the cost of the investment.
like a negative cash flow within the general formula of NPV and compare the result like this
obtained with the value or cost of the investment. The project will be accepted if the NPV is greater than the
cost of the investment. This second criterion presents the difficulty of presuming that the investment
It is paid in full at the initial moment, which may not be true for all cases.

This evaluation system is the most reliable, as the other methods present various
Application difficulties and their results can lead to erroneous conclusions. Must
It should be noted that the NPV of a project is not only an indicator that allows for ranking.
several projects, but also measures the value or surplus generated by the project by
above what would be produced by the same funds if the investment were not made.

17.2. Internal Rate of Return (IRR) :

10 Macroeconomics I

It is defined as the discount rate that makes the net present value of a given investment
is equal to zero. The IRR is obtained by solving the following equation:
n
ffffffffffffffffffffff Rt
X
t= 0 ` 1+ r at
Where:
RtNet cash flows in the period
n = Duration period of the project
Each of the periods
r = TIR

The decision rule that arises from the use of the IRR has two parts:
• In the case of independent projects, if r > i (where i is the opportunity cost of
capital for the investor), the project must be accepted.
• In the case of alternative projects, the project with the highest IRR should be chosen.
high.

The great advantage of using the IRR lies in the fact that it can be calculated using
only information coming from the project. However, the disadvantages of the IRR are
series:
• There are projects for which it is not possible to find a single rate of return.
When we are faced with a project where the financial profile is such that it
alternate periods of negative cash flow with periods of positive cash flow and the
"zero line" is crossed more than once; then we will have a project with more than
a TIR (Lorie-Savage cases) 2This is because in practice it is about the solution
of an equation of degree 'n', which has multiple solutions.
• It tends to penalize larger projects and favor smaller ones.
• It also penalizes long projects to the detriment of short projects, when
éstos no pueden ser repetidos.
• If it is about projects that start at different times in the calendar year,
penalizes those who start closer.
• The IRR method assumes that excess and/or shortfalls of funds are rewarded or
penalized respectively at the same rate, equivalent to 'r', which results in being rather unrealistic.
The reinvestment of surplus funds in a project does not usually yield the same rate as
the one that is paid for obtaining the original loan.

The marginal efficiency of investment (MEI) or the expected return on capital, along with the
interest rate, determine the amount of new investment, as well as the level of employment, given
the marginal propensity to consume. The EMgI is the ratio or proportion of two elements: a) the
expected returns of an asset and b) the offer price or cost of the asset that constitutes the
source of expected returns. Efficiency refers to return on cost of
a capital good, and the marginal effectiveness is the highest type of return on cost
what is expected from an additional unit. Therefore, a company must:
1. estimating the duration of the investment asset, taking into account the depreciation rate, is
to say the loss of utility or productive capacity from one year to another.
2. calculate the discounted present value of benefits (NPV) or (PV).
decide whether to acquire the investment asset or not. This decision clearly depends on the relationship
between the current value of expected benefits and the price of a machine.

18. Extensions to investment theory

18.1. Marginal Efficiency of Investment and Marginal Productivity of Capital

Keynes designated, perhaps imperfectly, the Marginal Efficiency of Capital to what is now
Marginal Efficiency of Investment. The distinction is important, given that what it measures
the investment impulse is the EMI, and this has differences with the Marginal Productivity of Capital
microeconomic.

The PMgK is interpreted as the marginal increases in the product due to increases
marginal in capital units. It is well known that capital is incorporated through investment,
and these increases will occur until the last unit of capital incorporated has a

2
For further references regarding the Lorie-Savage cases, consult Van Horne, 'Administration'
"Finance", Modern Accounting Publishing, 1977.
Macroeconomics I 11

equivalent cost (interest). The PMgK is understood as stable in the long term and dependent
rather of technology.

The EMI implies that investors will demand investment goods to the extent that the rate
internal return of them exceeds the cost of acquiring them. It is understood, therefore, that the
EMI is inherent to every investment project, while PMgK is relative to everything.
capital of the economy.

As investors carry out investment projects whose EMI is higher than the interest
current, the projects that are approved tend to decrease the weighted PMgK of the entire
capital. This decline or progressive degradation will theoretically continue until the last
approved investment project has an EMI equivalent to the current PMgK for the entire
economy3.

EMI
PMgK
i

EMI1EMI2 .... EMIN

K0

interest

PMgK

K
Relationship between the Marginal Productivity of Capital and the Marginal Efficiency of Investment

New investment projects can only be approved if new alternatives arise.

investors with higher EMI, or if, given the successive accumulation of capital in the economy, the
PMgK descends, giving rise to a new wave of investment projects.

18.2. The paradox of frugality

Rationally, one tends to think that saving is good for the economy of a country and that it is
preferable a a frugal population, than one that squanders and spends all its income. But our model
it leads us to surprising results. An economy that sees its propensity increase
marginal to saving reduces the equilibrium income level and ultimately saves in terms
absolutely, the same amount as before or even less.

We start from a situation of equilibrium Yowhere the condition S = I is met. When increasing
The PMgS, the savings curve turns upward and a new equilibrium is determined at Ye; lower.
at the beginning.. Families, by modifying their behavior towards savings, have also altered
consumption habits. The increase in savings implies a decrease in consumption that
lower demand. The decrease in demand causes an excess of goods, businesses see an increase
investment in stocks above desired values, stop placing their orders and the
production falls. As production decreases, savings decrease until again
matches the desired investment that has remained unchanged; therefore we conclude
saving the same in absolute terms: the necessary to finance an investment that has not
changed. In times of economic recession, aiming for the solution of our
Being more frugal (saving more and consuming less) tends to be a mistake that worsens.
the recession.

3
For further references, consult Warren Smith, Macroeconomics, Edit. Amorrortu.
12 Macroeconomics I

S,I S,I
S=So+s'Y S=So+s'Y
S=So+sY S=So+sY

I=Io I=bY

Ye Y0 Ye Y0
Y Y

Paradox of frugality

In Graph 1, where investment is autonomous, it is observed that an increase in the

marginal propensity to save decreases the income level, while keeping the level constant
of investment. In Graph 2, where investment is induced by the level of income, there
notice that with an increase in the marginal propensity to save, the level decreases
income and also decreases the level of investment.

18.3. Harrod-Domar Growth Theory

The first model that studies economic growth dates back to 1937, developed by Harrod and
To dominate, and what part of the theoretical equality between planned savings and investment:
S t= I t
Savings is equal to its average propensity multiplied by the income of the period, and investment.
is equal to the difference in capitals between periods:
sYt= Kt@Kt@ 1
Capitals are a constant relationship of income (principle of acceleration):
sYt = vY
b t@Y t @ 1 c

fffffffffffffffffffffffffffffffffsf Y t @Yt@1
= =g
v Yt
Consequently, the growth rate is a quotient between the average propensity to save and the
capital/product ratio (accelerator).

So an increase in the growth rate may come from an increase in the rate of
community savings (s), or a reduction in the capital/product ratio; that is, that it
they need fewer 'units' of capital to obtain a 'unit' of product, that is, that the
capital more productive.

One possible conclusion of this model is that the Keynesian policy of redistribution of
short-term income (which tends to increase the consumption of the poor at the expense of
savings of the rich) would result in being incompatible with the maintenance of a savings rate "s"
sustainable in the long term.

18.4. Investment and Savings in an Open Economy

In a closed economy, completely isolated from the rest of the world, total savings would be, by
need, equal to aggregate investment. The product of the economy is divided between consumption
investment flow, so that Y = C + I. At the same time, the income received by the
families, which is also equal to Y, must be divided between consumption and savings, so that Y = C +
We immediately see that I = S, that is, investment must always be equal to savings.
Both saving and investment represent that part of the national product that is not
used for current consumption.

Of course, savings and investment in an economy do not necessarily correspond to the

same families, or companies. Some families may wish to save without having any projects.
Macroeconomics I 13

of investment to be made, while other families may have investment projects but
lacking savings. Financial markets solve the problem of channeling savings.
towards those looking to invest. Through them, savers accumulate financial assets.
while investors accumulate financial liabilities. For example, we could
suppose that investors could issue bonds to finance their investments, which
they would be acquired by families who want to save.

However, in an open economy, where the residents of a nation trade goods

and financial assets with residents of other economies, it is no longer effective that the
The savings of a nation must always be equal to the investment that takes place within the country. The
families of a nation may want to save more than they try to invest in the field
domestic, lending the excess savings to investors from other countries. In this case the country
will accumulate net financial assets against residents abroad. The national product that will
It is generated but not consumed or invested; it is exported abroad. As we will see, there is a
intimate relationship between a country's Savings - Investment balance and its net exports.

18.5. Deficiencies in investment measurement

Investment is the flow of product used to maintain or increase the capital stock.
of the economy. Although fixed industrial investment, inventories, and housing are the three
main categories of investment that are measured in the National Accounts, they are not the
unique types of investment in the true economic sense of expenditure on durable goods that
they increase the future productive capacity of the economy.

Durable consumer goods, such as cars, refrigerators, dishwashers, etc.

they provide consumer services over many periods. Consequently, the acquisitions
new durable consumer goods should be considered as a form of expenditure
investment and the total stock of durable consumer goods should be considered part of the stock of
capital. But normally spending on these goods is counted as consumption expenditure in the
national income accounts and not as investment expenditure. In general, government spending on
roads and infrastructure is also a form of investment spending, but it is included among
consumer expenditure in national accounts.

So far, the types of capital mentioned are called 'reproducible capital' because their stock
can increase through new production: companies can invest in new plants and
equipment, people can build new houses, etc. There is another type of capital, which includes the
land and mineral deposits, which is "non-reproducible" in the sense that it cannot
increase through production. Mineral deposits are also 'exhaustible', that is, to
the measures that are used are running out. In economic terms, the pumping of a well
oil-related, or the exploitation of a mineral vein represents a form of negative investment,
or disinvestment, since the stock of the resource decreases as it is extracted. As a rule
generally, national accounts do not account for these activities as negative investment. This
types of concepts are taken into account in more sophisticated and modern systems
accounting -still not generalized- referred to as the System of Environmental Accounts.

Official data also ignores many other types of non-physical capital that should be taken into account.
to account for in a country's capital stock. A well-trained workforce incorporates a
type of human capital, since the training of workers (education, training in
employment increases the productive capacity of the workforce.

However, this type of expenditure is misclassified in the national accounts as expenditure of

consumption and not as investment expenditure. Spending on research and development is another way to
of investment in non-physical capital of the economy, in terms of a higher level of technology
sophisticated is part of the global capital stock of an economy. For all these reasons,
there is a tendency to significantly underestimate the magnitude of investment spending in the
economy, as there is a tendency to exaggerate the magnitude of consumer spending.

Basic bibliography

Blanchard – Pérez Enrri. “Macroeconomics. Theory and economic policy with applications to
Latin America. Prentice Hall
Dornbusch - Fischer. "Macroeconomics". Mc Graw Hill
Sachs - Larrain. 'Macroeconomics in the Global Economy'. Prentice Hall

Additional bibliography
14 Macroeconomics I

O'Kean, José María. "Analysis of the Economic Environment of Businesses", McGraw Gill
Warren Smith.“Macroeconomía”, Amorrortu
Brooman. "Investment", University Alliance