Investment Functions Prof. Tarun Das

8/14/2019 Investment Functions Prof. Tarun Das

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Prof. Tarun Das, IILM EEP Session-6 1

Economic Environment

and Policy (EEP)Session-6

Investment MultiplierAnd Business Cycles

Dr. Tarun Das, Professor, IILM


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Contents of this presentation

1. Investment function, investmentmultiplier and accelerator

2. Numerical examples

3. Types of business cycles4. Causes of business cycles5. Macro variables and business

cycles


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1.1 Investment Function andAccelerator

Investment is the rate of change of

capital accumulation over time.It = Kt = Kt kt-1

Capital/output ratio (COR) = Kt / Yt

Incremental capital/output ratio (ICOR)

= Kt / YtKt = w. Yt, where w = COR = ICOR

It = Kt kt-1 = w (Yt Yt-1) = w YtThe basic relationship between change ofoutput and volume of investment is known as

accelerator principle. The capital/outputratio w is known as the accelerator.


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1.2 Investment MultiplierInvestment multiplier is the ratio ofincremental income to incremental

investment.Investment multiplier = Yt / It

Yt = Ct + It = + Yt +It

Or, Yt - Yt = + ItOr. (1- ) Yt= + It

Or, Yt = / (1- ) + 1/ (1- ) ItInvestment multiplier = Yt / It = 1/ (1- )

= 1/ (1-MPC) = 1/ MPS.Investment multiplier varies directly withMPC and inversely with MPS.


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2.1 Numerical Example: Multiplier

Problem-1: Given consumption functionC=50+0.75 Y or savings function S=-50+0.25 Y,

Estimate investment multiplier. If investmentrises by Rs.100 Crore, what is the increase ofincome? How is additional income distributedbetween savings and consumption?Answer: Here, MPC=0.75, MPS=0.25Investment multiplier = 1/ (1-MPC) = 1/ MPS= 1/ 0.25 = 4.If investment rises by Rs.100 Crore, income risesby Rs.400 Crore. Then, consumption rises byMPC*Y = 0.75*400 = Rs.300 Crore and savingsrises by Rs.100 Crore.


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2.2 Numerical Example: ICOR

Problem-2: Given average real GDP growth

rate of 9% and average investment ratio of36%, estimate ICOR. Assuming that ICORdeclines by 5% due to increase ofproductivity, how much investment isrequired if we plan for a growth of 10% per

annum?Answer: ICOR = 36/9 =4.If ICOR declines by 5%,new ICOR=95% of 4 = 3.8

So required investment for a growth rate of10% = 3.8 * 10 = 38%.


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2.3 Equilibrium Income withgovernment

Problem-3: Let consumption depends on

disposable income and consumptionfunction is given by: C=50+0.75 (Y-T).Further assume that average tax rate is20% and govt maintains a balanced

budget. If domestic private investmentequals Rs.100 Crore, find outequilibrium level of income,consumption, savings and taxes.


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2.4 Equilibrium Income withgovernment

Answer:T = 0.2 * Y= govt expenditure (G) asgovt maintains a balanced budget.

C=50+0.75(Y-T)=50+0.75(Y-0.2Y)=50+0.6Y

Y=C+S+T=50+0.6Y+100+ 0.2Yas S=I=100.

Or, Y= 150+0.8YOr, Y-0.8Y = 150. OR, Y=150/0.2=750.T=0.2*750=150 =GC=50+0.75 (750-150) = 500S=Y-C-T=750-500-150=100

Check: Y=C+S+T=500+100+150=750Y=C+I+G=500+100+150=750.


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3.1 What is the Business Cycle?

Business cycles are periodic but

irregular up-and-downmovements in economic activity:such as real GDP, employment,profits etc.

Its timing is random, and to alarge degree, unpredictable.

A business cycle is identified as asequence of four phases:

1.Recession,2.Trough,3.Boom,4.Peak


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3.2 Phases of Business Cycle

1.Contraction, Recession, Slum,

Depression (A slowdown in the paceof economic activity); A recessionoccurs if a contraction is severeenough. A deep trough is called aslump or a depression.

2.Trough (The lower turning point of abusiness cycle, where a contractionturns into an expansion);

3.Expansion, Prosperity, Boom (Aspeedup in the pace of economicactivity);

4.Peak(The upper turning of a businesscycle, where an expansion turns into acontraction).


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3.3 Different phases of businesscycles

Trough

Peak

ContractionExpansion

Time

variable


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3.4 Business Cycles are Irregular

In many ways, the term business cycleis misleading.

Cycle seems to imply that there issome regularity in the timing andduration of upswings and downswings in

economic activity. Most economists, however, do not think

so. For describing the swings in economic

activity, therefore, many moderneconomists prefer the term short-runeconomic or business fluctuations tobusiness cycle.


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3.5 Types of Business Cycles

Main types of business cycles havebeen named after their exponents.

The Kitchin inventory cycle (35 years) after Joseph Kitchin,

The Juglar fixed investment cycle (711years) after Clement Juglar,comprising four stages:

1. expansion = rise in production andprices, and low interests rates.

2. crisis = stock exchanges crash andseveral companies become bankrupt.

3. recession = decrease in price and inoutput, high interests rates.4. recovery= stocks recover thanks to the

fall in prices and incomes.


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3.6 Types of Business Cycles

The Kuznets infrastructural investmentcycle (1525 years) after SimonKuznets, Nobel Laureate,

The Kondratieff industrial wave orinnovation cycle (4560 years) afterNikolai Kondratieff.

The Forrester generation cycles (200years) - after Jay Wright Forrester.

The Toffler civilization cycles (1000-

2000 years) - after Alvin Toffler.

4 1 B i C l (BC)


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4.1Business Cycle (BC)variables

Business cycles are generally measured

by movements or growth rates of realGDP, capital and investment.

The four primary economic fluctuations

are secular trend (T), business cycle (C),seasonal (S), and random (R).

Multiplicative Model: V=T*C*S*R

Additive Model: V=T+C+S+R


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.Cycles-

Trend in Real GDP in USA in 1955-2005


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4.3 Log Real GNP and Trend


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4.4 Deviations from Trends in LogGNP


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4.5 Figure depicts fluctuations in GNP andconsumption. Observe how peaks andtroughs align and how upturns and

downturns coincide.


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5.1Causes of Business Cycles

Just as there is no regularity in the timing

of business cycles, there is no reason whycycles should occur at all.

Business cycles occur due to somedisturbances, which pull the economyabove full employment or push it below.

Inflationary booms are generated by surgesin private or public spending.

Similarly, a wave of optimism or feel goodfactors cause consumers to spend more

than usual and firms to build up newcapacities than necessary.


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5.2Causes of Business Cycles

Recessions or depressions can be causedby the same forces working in reversedirections.

A substantial cut in government spendingor a wave of pessimism amongconsumers and firms may cause theoutput of all types of goods and servicesto fall.

Another possible cause of recessions andbooms is monetary policy.

A firm faced with high interest rates maydecide to postpone building a new

factory. Households may be lured by cheap

housing loans, and construction activitiesmay boom.

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5.3Political Theory of BusinessCycles

The partisan theory of business cyclesuggests that cycles result from thesuccessive elections of administrationswith different policy regimes.

Regime A adopts expansionary policies,resulting in growth and inflation, but isvoted out of office when inflationbecomes unacceptably high and hurtseverybody.

The replacement, Regime B, adoptscontractionary policies reducing inflationand growth, and the downwards swing of

the cycle. It is voted out of office whenunemployment is too high, being replacedby Party A.


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6.1Co-movement of variables Many economic indicators move together

during business cycles. During an

expansion, not only output rises, but alsoemployment and profits rise.

Construction, retail and financial servicesalso rise, and inflation may rise if theexpansion is too brisk.

Conversely, during recession, outputs ofgoods and services falls, employment falls,construction falls, and prices of consumergoods and wages also fall.

Recession is a period when a broad range of

economic indicators falls for a sustainedperiod, roughly at least half a year.


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6.2Cyclical behavior of macro economicvariables and BC indicators

According toDirection of change: variablescan be classified as procyclical,countercyclical or acyclical.

Procyclical- Variables have positivecorrelation. They usually increase duringbooms and decrease during recessions.

Consumption, investment and employmentare strongly procyclical.

Countercyclical- Variables have negativecorrelation. Unemployment is countercyclical.

Acyclical- Variables have zero correlation,

implying no systematic relationship to thebusiness cycle . capital stock is acyclical.


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6.3 Cyclical behavior of macro economicvariables and BC indicators

According to Timing of Occurrence:variables can be classified as leading,coincident or lagging variable.

Leading Indicator: which occurs ahead of theoccurrence of business circle variable.

Coincident Indicator: which move up and downalong with the business cycle variable.

Lagging Indicator: which follow the business

cycle variable after some time lag.


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6.4 Leading Indicators

New employment

New orders for consumer durable goods

Stock Index

New orders for plant and equipment

Building permits for private houses Deliveries by Companies

Index of consumer confidence

Index of business confidence

Inflation

Money growth rate (M2)


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6.5 Coincident Indicators

Nonagricultural employment Index of industrial production

Personal income

Manufacturing and trade sales


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6.6 Lagging Indicators

Wage rates Rate of inflation

Consumer credits

Lending rates Outstanding loans


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6.7 Cross Classification of Indicators

Items Direction of change

Time ofoccurrenc

eIndustrial output procyclical coincident

Capacity

utilization

procyclical coincident

Employment procyclical coincident

Unemployment countercyclical

coincident

Inflation rate procyclical lagging

Corporate profits procyclical coincident


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Thank you

Have a Good Day

Investment Functions Prof. Tarun Das

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