1. Chapter Four Investment Spending and Multiplier

2. 1. Investment Decision: Three Methods Present value Expected returns Expected returns Expected costs Expected costs

3. For example: A project expected to generate $500 of income and to cost $401 to operate; left is $99. A project expected to generate $500 of income and to cost $401 to operate; left is $99. Assuming an investor can earn 10% with his money elsewhere, he would be willing to pay $90 for the capital good. Assuming an investor can earn 10% with his money elsewhere, he would be willing to pay $90 for the capital good. Is the project worth of investing or not ? Is the project worth of investing or not ?

4. Total cost vs. Total revenues TR: P×Q TR: P×Q TC: three components TC: three components value of capital assets value of capital assets borrowing cost borrowing cost operating costs operating costs Example. Example.

5. The Marginal Efficiency of Investment (MEI) MEI is the rate of return that equates the expected flow of revenues in excess of expected non-capital costs (efficiency) from one additional newly constructed asset to the cost of purchasing the asset (investment). MEI is the rate of return that equates the expected flow of revenues in excess of expected non-capital costs (efficiency) from one additional newly constructed asset to the cost of purchasing the asset (investment).

6. 2. MEI Curve for Firm MEI Investment

7. Derivation of the MEI curve Why the MEI curve negatively slopes to the right ? MEI curve I i

8. 3. Investment decision: factors analysis expected revenue expected revenue interest rate interest rate accelerator effect accelerator effect new technologies; new products; new technologies; new products; new resources; new population growth. new resources; new population growth. 4. Investment Function autonomous investment autonomous investment induced investment induced investment investment function investment function I = I 0 + e Y I = I 0 + e Y

9. 5. Equilibrium Output (GDP) Simple Economy ( two sectors) Simple Economy ( two sectors) A) Equilibrium output : A) Equilibrium output : 45° degree methods 45° degree methods B) Equilibrium condition : I=S B) Equilibrium condition : I=S Formula for equilibrium output : Formula for equilibrium output : AD=Y=C+I=a+bY+I=GDP; AD=Y=C+I=a+bY+I=GDP; Y=[1/1-b]a+I Y=[1/1-b]a+I

10. 6. Gap Difference between the equilibrium output and full employment output Deflation gap and inflation gap 7. Thrift paradox: views on saving Classical view Modern view

11. 45° Equilibrium output Full employment output AD AD’ Deflation gap Y

12. 8. Multiplier Definition------is the amount by which equilibrium output changes when autonomous aggregate demand increases by one unit Example: Investment Multiplier Formula for Multiplier Multiplier in Pictures

13. Some problems 1. Suitability 2. Duality 3. Limitation Multiplier effects Consider: one time investment and successive investment one time investment and successive investment