MACROECONOMIC

ENVIRONMENT
4. INVESTMENT
FUNCTION

Introduction
Investment:
Links the present to the future
Links the goods and money markets
Drives much of the business cycle.

We wish to study how investment depends on

interest rates and income.
Investment is the most volatile sector of
aggregate demand; changes in investment
account for much of the change in GDP.

Introduction
Investment is the flow of spending that adds to the stock
of capital.
Both GDP and investment are flow variables.
Capital is the rupee value of all the buildings, machines,
and inventories at a given point in time - stock value.
Investment is the amount spent by businesses to add to
the existing capital stock over a given period.
Flow of investment is quite small compared to the stock of
capital.
The theory of investment is the theory of the demand for
capital.

The Desired Capital Stock

Firms use capital, along with labor and other resources, to

produce output. The goal of a given firm is to maximize profits.
- When deciding the optimal level of capital, firms must
balance the contribution that more capital makes to their
revenues against the cost of acquiring additional capital.
- The marginal product of capital is the increase in output
produced by using 1 more unit of capital in production.
- The rental (user) cost of capital is the cost of using 1 more
unit of capital in production.

The Desired Capital Stock

To derive the rental cost of capital:
firms finance the purchase of capital by borrowing over time, at an
interest rate of n.
In the presence of inflation, the real cost of capital(r) differs from the
nominal cost of capital(n).
Real cost of capital (r) = nominal interest rate(n) inflation rate(e).
At the time the firm makes an investment, the nominal interest rate is
known, but the inflation rate for the coming year is not.
Real cost of borrowing is the expected real interest rate:
Capital wears out over time - rc must include depreciation, d.
The complete formula
rc for
r thed rental
n cost
e of dcapital is:

The Desired Stock of Capital

Firms

add capital until the marginal

return of the last unit added drops to
the rental cost of capital.
Diminishing

MPK means that each

successive unit of capital yields less than
the previous unit.
An

increase in the rental cost of capital

can only be justified by an increase in the
MPK, and a lower level of K.
The

We assume that the total population and

aggregate labor input and the level of
technology remain constant.

relationship among the desired

capital stock, K*, rc, and output is -

K * g ( rc , Y )

The Desired Stock of Capital

_

K g ( rc , Y )
*

An increase in rc decreases K*. An increase in Y

increases K*.
Tax holidays decrease rc. An increase in
corporate tax rate increases rc.
An investment tax credit (subsidy) by govt
reduces rc.

Tax Incentives In India

Tax Incentives In India focus mainly on establishing new industries,
encouraging investments in underdeveloped areas, infrastructure, &
promoting exports.
a)location based : Tax holidays in specified locations such as
NE; state level incentives.
Key incentive includes deduction of 100% of profits of the qualifying
unit for 10 consecutive years.
b)Export Linked : Benefit for R&D expenditure; SEZ developer.
SEZ developers are granted deduction of 100% of export profits for
first 5 yrs, deduction of 50% of export profits for next 5 years,
deduction of 50 % of export profits for further 5 yrs provided that
these profits are used for acquiring plant/mch within 3 yrs.

Tax Incentives In India

b) Export Linked : Benefit for R&D expenditure.
In house R&D facility eligible for deduction @ 200%. All
capital expenditure as approved by DSIR on in house R&D
eligible.
c) Industry Specific : Infrastructure & power; oil & gas; cold
chains & warehousing; hospitals; fertilizer production;
affordable housing project schemes; hospitality & tourism.
Investment allowance @ 15% of the actual cost of the new
asset acquired and installed during the tax year 2013-15 if
aggregate investment > Rs1000 million.

Tax Incentives In India

Infrastructure
The deduction of 100 percent of business profits is permitted for a period of 10
years for:
The development, operation, or maintenance of ports, airports, roads, highways,
bridges, rail systems, inland water ways, inland or outland ports or navigational
channels, water supply projects, water treatment systems, irrigation projects,
sanitation and sewage projects, and solid waste management systems; The
generation and distribution of power commencing before March 31, 2010; Laying
and operating a cross-country natural gas distribution network
Hospitals
The deduction of 100 percent of profits from businesses operating and maintaining
a hospital for a period of 5 years for:
Hospitals that were constructed or began functioning any time between April 1,
2008 and March 31, 2013;
Hospitals with at least one hundred beds for patients.

Tax Exemptions

The following tax exemptions are available in different sectors, and allow
for deductions of 100 percent profits for:
The development, operation, and maintenance of an industrial park or Special
Economic Zone (SEZ).
Undertakings in certain notified areas or in certain thrust sector industries in the
Northeastern states and Sikkim.
Undertakings set up in certain notified areas or in certain thrust sector
industries in Uttaranchal and Himachal Pradesh.
The export of articles or software by undertakings in FTZs, electronic and
hardware technology parks, and software technology parks.
The export of articles or software by 100 percent export oriented units.
Undertakings engaged in the integrated business of handling, storing, and
transporting food grains.
Undertakings engaged in the commercial production or refining of mineral oil.
Undertakings engaged in the export of wood based handicrafts.

Tax Exemptions, 2016

Three Year Tax Holiday For Startups.
Startups can now enjoy 100 per cent tax exemption for the first
three years. Finance minister announced 100% deduction of
profits for startups adhering to certain conditions Make in India
Policy, set up during April 2016 to March 2019.
New manufacturing firms from March 1, 2016, shall be taxed at
25 per cent (plus cess and surcharge). No further exemptions
shall be available for new companies if taxed at 25 per cent. The
erstwhile flat corporate tax rate was 30 per cent (plus cess and
surcharge).

Tobins q
The q theory of investment restates the marginal benefit equals marginal
cost rule in more easily quantifiable terms. It points out that that the price
of a companys stock, is a measure of the value of that capital. Likewise,
the amount of money that would be required to replace all of the capital
that a firm owns is a measure of that firms cost of capital.
Looking at the ratio of the market value of a firm (the number of shares of
stock it has issued times the market value of those shares) to that firms
replacement cost of capital, we get the q ratio -

market val
ueof firm
replacemen
t costof firm's capital

The q ratio tells us something about the ratio of marginal benefits to

marginal costs: A q greater than 1 suggests that the benefit of acquiring
new capital exceeds the cost, or that the firm should invest more. A q
smaller than one suggests that the cost of acquiring new capital is
greater than the benefit, or that the firm should disinvest -allow its capital
stock to fall. A q exactly equal to 1 suggests that the firm has exactly the
right amount of capital, or capital is at its desired level.

Capital Stock Adjustment

The rate of investment depends on the difference between
the actual capital stock (K) and the desired capital stock (K*).
The flexible accelerator model is based on the notion that
firms with larger gaps between their actual and desired
capital stocks should be investing more than firms whose
actual capital stock is closer to its desired level. It assumes
that firms try to close some fraction, , of this gap each
period, or that

I K K 1 K * K 1

where K1 represents the capital stock that the firm had at the
end of the previous period.
Equation shows investment spending as a function of K * and
K-1. Any factor that increases K*, increases the rate of
investment.

Capital Stock Adjustment

Figure illustrates how the

capital stock adjusts from
an initial level of K-1 to the
desired level K*.
Upper panel shows the
stock of capital.
Lower panel shows the
corresponding level of I.

Monetary, Fiscal Policy & Desired Capital

Stock
K* increases when rc falls and when expected Y
increases. Increase in K* affects I spending.
roi is a prime determinant of the cost of capital.
Loose MP lowers roi and increases the K*.
A high tax-low G policy keeps roi low & increases K*. A
low tax-high G policy keeps roi high and decreases K*.

Investment and Aggregate Supply

Investment is a component of aggregate
demand, but doesnt it also increase potential
output? In the long run, yes.
Investment is one of the most effective ways to
expand capacity. In fact, countries which invest
a substantial fraction of their output tend to grow
much faster than countries which do not.
But the supply-side effects of any type of
investment are rarely felt in the short run, so can
be ignored since Keynesian macroeconomics is
short run macroeconomics.

India Data

India Data
Indias success in raising its average growth rate of the
economy in the Eleventh Five Year Plan period (200712) is a result of its inherent strength, which includes (i)
high level of domestic investment and savings rates, (ii)
high level of domestic consumption, (iii) the demographic
dividend that the country is reaping recently, (iv)presence
of robust corporate sector and (v) sustained fiscal
consolidation.
Investment Rate is the most important driver of GDP
growth.

India Data

India Data