Nta UGC-NET dec-2018

Online batch ,Lecture-20

Macro eco Topic- 5

THEORIES OF investment

UGC-NET PAPER-2 (ECO)

THEORIES OF investment
 # 1. The Accelerator Theory of Investment:

The accelerator principle states that an increase in the rate of output of a

firm will require a proportionate increase in its capital stock.

The capital stock refers to the desired or optimum capital stock, K.

Assuming that capital-output ratio is some fixed constant, v, the

optimum capital stock is a constant proportion of output so that in
any period t,

The accelerator theory of investment, in its simplest form, is based upon

the notion that a particular amount of capital stock is necessary to
produce a given output.
 Thus, X = Kt /Yt

where x is the ratio of Kt, the economy’s capital stock in

time period t

Yt, its output in time period t.

The relationship may also be written as

Kt = xYt

If X is constant, the same relationship held in the previous

period.
 Kt-1 = xYt-1

Since net investment equals the difference between the capital

stock in time period t and the capital stock in time period t – 1,

net investment equals x multiplied by the change in output from

time period t – 1 to time period t.

net investment equals x, the accelerator coefficient, multiplied

by the change in output.

Consequently, Since x is assumed constant, investment is a

function of changes in output.
If output increases, net investment is positive. If output increases
more rapidly, new investment increases.

According to the theory,

a particular amount of capital is necessary to produce a given level

of output.

For example, suppose Rs. 400 crore worth of capital is necessary

to produce Rs. 100 crore worth of output.

This implies that x, the ratio of the economy’s capital stock to its
output, equals 4.
 In the upper portion, the total output
curve Y increases at an increasing rate
up to t + 4 periods,

then at a decreasing rate up to period t + 6.

After this, it starts diminishing.

The curve In in the lower part of the figure,

shows that the rising output leads to
increased net investment up to t + 4
period because output is increasing at an
increasing rate.
But when output increases at a
decreasing rate between t + 4 and t + 6
The above explanation is based on the periods, net investment declines.
assumption that there is symmetrical
When output starts declining in period t
reaction for increases and decreases of
+ 7, net investment becomes negative.
output.
 criticisms.

1.the theory explains net investment but not gross investment.

2.The theory assumes that a discrepancy between the desired and actual capital
stocks is eliminated within a single period.

3.Since the theory assumes no excess capacity.

4. the accelerator theory of investment, or acceleration principle, assumes a

fixed ratio between capital and output.
 #2 . Tobin’s Q Theory of Investment:

Nobel laureate economist James Tobin has proposed the q theory of investment

which links a firm’s investment decisions to fluctuations in the stock market.

When a firm finances its capital for investment by issuing shares in the stock
market, its share prices reflect the investment decisions of the firm.

Firm’s investment decisions depend on the

following ratio, called Tobin’s q:

Market Value of Capital Stock

Q=
Replacement Cost of Capital
The market value of firm’s capital stock in the numerator is the value of its capital
as determined by the stock market.

The replacement cost of firm’s capital in the denominator is the actual cost of
existing capital stock if it is purchased at today’s price.

Thus Tobin’s q theory explains net investment by relating the market value of firm’s
financial assets (the market value of its shares) to the replacement cost of its real
capital (shares).

According to Tobin, net investment would depend on whether q is greater than

(q>1) or less than 1 (q<1).

If q> 1, the market value of the firm’s shares in the stock market is more than the
replacement cost of its real capital, machinery etc.

The firm can buy more capital and issue additional shares in the stock market.
In this way, by selling new shares, the firm can earn profit and finance
new investment.

Conversely, if q<1, the market value of its shares is less than its
replacement cost and the firm will not replace capital (machinery) as
it wears out.

The demand for capital depends mainly on two factors.

First, the level of wealth of the people. The higher is the level of
wealth, the more shares people wish to have in their wealth portfolio.

Second, the real return on other assets such as government bonds

or real estate.
 Panels (A) and (B) shows how an increase in
Tobin’s q induces a rise in the firm’s new
investment.

It shows that an increase in the demand for

shares raises their market value which raises
the value of q and investment.

The demand for capital is shown by the

demand curve D in Panel (A).

The initial equilibrium is determined by the

interaction of demand for capital and the available
The new equilibrium is established at supply of capital stock OK at point E, which is fixed
E1 in the long run when the replacement in the short run.
cost rises and equals the market value If rise in the value of Tobin’s q above unity.
of capital.

This is shown as the rightward shift of the

The rise in the value of q to q1 induces an demand curve to D 1.
increase in new investment to OI, as shown in
Panel (B).
 # 3. The Internal Funds Theory of Investment:

Under the internal funds theory of investment, the desired capital stock and,
hence, investment depends on the level of profits.

Jan Tinbergen, for example, has argued that realized profits accurately reflect
expected profits.

Since investment presumably depends on expected profits, investment is

positively related to realized profits.
Firms may obtain funds for investment purposes from a variety of
sources:

(1) Retained earnings,

(2) Depreciation expense (funds set aside as plant and equipment depreciate),

(3) Various types of borrowing, including sale of bonds,

(4) The sale of stock.

Retained earnings and depreciation expense are sources of funds internal to the
firm; the other sources are external to the firm.

Borrowing commits a firm to a series of fixed payments.

Internal funds theory of investment argue that firms strongly prefer to finance
investment internally and that the increased availability of internal funds
through higher profits generates additional investment.

Thus, according to the internal funds theory, investment is determined by

profits.

According to the internal funds theory, policies designed to increase profits

directly are likely to be the most effective.

In contrast, investment, according to the accelerator theory, is determined by

output.

Acc to them increases in government purchases or reductions in personal

income tax rates will have no direct effect on profits,

hence no direct effect on investment.

To the extent that output increases in response to increases in government
purchases or tax cuts, profits increase.

Consequently, there will be an indirect effect on investment.

 4. Jorgensons’ Neoclassical Theory of Investment:
Jorgenson has developed a neoclassical theory of investment.

His theory of investment behaviour is based on the determination of the optimal

capital stock

His investment equation has been derived from the profit maximisation theory of
the firm.

Assumptions:

1. The firm operates under perfect competition.

2. There is no uncertainty.

3. There are no adjustment costs.

4. There is full employment in the economy where prices of labour and capital are
perfectly flexible.
5. There is a perfect financial market which means the firm can borrow or lend at a
given rate of interest.
6. The production function relates output to the input of labour and capital.

7. Labour and capital are homogeneous inputs producing a homogeneous output.

8. Inputs are employed upto a point at which their MPPs are equal to their real unit
costs.

9. There are diminishing returns to scale.

10. The capital stock is fully utilised.

11. Changes in current prices always produce ceteris paribus proportional changes
in future prices.
 Neoclassical Theory of Investment:

The theoretical basis for the neoclassical theory of investment is the neoclassical
theory of the optimal accumulation of capital.

According to the neoclassical theory, the desired capital stock is determined by

output and the price of capital services relative to the price of output

As in the case of the accelerator theory, output is a determinant of the desired

capital stock.
Thus, increases in government purchases or reductions in personal income tax
rates stimulate investment through their impact on aggregate demand, hence,
output.

According to the neoclassical theory, however, business taxation is important

because of its effect on the price of capital services, not because of its effect on
the availability of internal funds.
In contrast to both the accelerator and internal funds theories, the
interest rate is a determinant of the desired capital stock.

Thus, monetary policy, through its effect on the interest rate, is

capable of altering the desired capital stock and investment.
 #5. The Profits Theory of Investment:

The profits theory regards profits, in particular undistributed profits, as a source of

internal funds for financing investment.

Investment depends on profits and profits, in turn, depend on income.

In this theory, profits relate to the level of current profits and of the recent past.

If total income and total profits are high, the retained earnings of firms are also
high, and vice versa,

Thus if profits are high, the retained earnings are also high.

The cost of capital is low and the optimal capital stock is large.

That is why firms prefer to reinvest their extra profit for making investments instead
of keeping them in banks in order to buy securities or to give dividends to
shareholders.
 #6. Duesenberry’s Accelerator Theory of Investment:

J.S. Duesenberry in his book ‘Business Cycles and Economic Growth’ presents an
extension of the simple accelerator and integrates the profits theory and the
acceleration theory of investment.

Duesenberry has based his theory on the following propositions:

(1) Gross investment starts exceeding depreciation when capital stock grows.

(2) Investment exceeds savings when income grows.

(3) The growth rate of income and the growth rate of capital stock are
determined entirely by the ratio of capital stock to income.
He regards investment as a function of income (Y), capital stock (K), profits and
capital consumption allowances (R). All these are independent variables and
can be represented as

I = f(Y t-1 , Kt-1, t-1 , Rt)

Where t refers to the current period and (t-1) to the previous period.

According to Duesenberry, profits depend positively on national income and

negatively on capital stock.
 #7. The Financial Theory of Investment

The financial theory of investment has been developed by James Duesenberry.

It is also known as the cost of capital theory of investment.

The accelerator theories ignore the role of cost of capital in investment decision by
the firm.

This theory assume that the market rate of interest represents the cost of capital.

It means that unlimited funds are available to the firm at the market rate of interest.
In other words, the supply of funds to the firm is very elastic.

In reality, an unlimited supply of funds is not available to the firm in any time period
at the market rate of interest.
As more and more funds are required by it for investment spending,
the cost of funds (rate of interest) rises.

To finance investment spending, the firm may borrow in the market at

whatever interest rate funds are available.
 Sources of Funds:

Actually, there are three sources of funds available to the firm for investment which
are grouped under internal funds and external funds.

(1) Retained earnings which include undistributed profits after taxes and
depreciation allowances are internal funds.

(2) Borrowing from banks or through the bond market; and borrowing through equity
financing or by issuing new stock (shares) in the stock market are the sources of
external funds.
1. Retained Earnings:

Retained earnings are the cheapest source of funds because the cost of using these
funds is very low in the short run.

There is no risk involved in spending these retained earnings or to repay debt.

 2. Borrowed Funds:

When the firm needs funds more than the retained earnings, it borrows from the
banks or through the bond market.

The cost of borrowed funds (rate of interest) rises with the amount of borrowing.

3. Equity Issue:
A third source is equity financing by issuing new shares in the stock market.

The imputed cost of equity funds is more costly than the opportunity cost of
retained earnings or borrowed funds.

Duesenberry points out that “the yield cost of equity finance is usually of the
order of 7 to 10 percent for large firms.
 Nta UGC-NET dec-2018
Online batch ,Lecture-21

Macro eco Topic- 6

Concept of money,qtm
&
Keynesian theory of money
UGC-NET PAPER-2 (ECO)