Macroeconomics II is divided in to six chapters

 The first Chapter discusses the theories of investment.

 The second chapter is about theories of money demand and supply;

 The third chapter that presents the macroeconomic policy debates

 Chapter four is concerned with models of economic growth

 The fifth chapter deals with the macroeconomic aspects of labour market.

 The sixth chapter present a review of the applicability of conventional

macroeconomic tools for the developing world with special reference to African
economy.
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 CHAPTER 1
THEORIES OF INVESTMENT

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1.1.THE MEANING AND RATIONALES FOR INVESTMENT

 The concept and process of investment can be defined from different

angles depending on who invest, the size of resources involved and the
area of investment.

 Investment can be defined as the process of putting ones resource (money)

in a given system with expectation of some benefits (more income,…).

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EXAMPLES OF INVESTMENT PROCESS

Establishing a production plant or factory;

Opening a new business;
Depositing money in saving accounts;
Constructing public infrastructures such as road, schools and hospitals and
Building business centers or residential houses and so on.

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 Investment is considered as an important part of national income accounts.

 Gross investment or net investment

 Gross investment represents the total sum of spending on one or more of

the items mentioned above.
 If we deduct an allowance for the existing structures and producers durable
equipment used up in producing the output, we get net investment.

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 For example, a machine can produce goods and services but at the same
time machines wears and tears.
 This is known as depreciation, which should be replaced by fresh
investments.
 Net investment is given by the gross investment less allowances for
such depreciations.

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 Some of the major factors that affect investment decision

Market demand (required for investment in production).

 The larger the market demand the larger the level of investment would be
Financial resource.
 The availability of enough financial resource also has positive implication for the
level of investment.
Political factors (political stability). It encourages investment.
Level of uncertainty (level of risk). The higher the level of uncertainty the lower
the incentive for investment will be (unstable political situation, price fluctuation,
…)

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Availability and efficiency of banking system. Its existence facilitates
investment process and so affects its size positively.
Government economic or investment policy. Conducive investment and
related economic policies encourage investment and increases its level.
Interest rate (cost of borrowing). Higher interest rate means high cost of
borrowing and so affects investment negatively.
This also implies that lower interest rates encourage investment for two
reasons:
low cost of borrowing and unattractive interest income to save money

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 Besides the aforementioned factors
 size of liquid assets at dispose of the investor,
 level of development in research and development,
 population growth and future consumers demand.

 Yet, several macroeconomists emphasize that the market interest rate is

the major determinant of investment level or investment demand.

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1.2.PURPOSE/MOTIVE OF INVESTMENT

We can divide the reasons why agents invest in to two major motives:

 Profit motive and

 Non-profit motive

 Most of the private investors have profit motive whereas

 Government and non-governmental organizations may involve in
investment projects because of non-profit motives such as welfare and
national growth issues.

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A. PROFIT MOTIVES

 People or individuals like to invest their money on new plants and

equipment because they believe that this helps them to make profit.
 As investment in capital goods remains for many years before it brings
profit, one can learn only after several years whether the investment is
profitable or not.
 The return to investment in plant and equipment is spread over a number
of years.
 For example, a manager who has invested in a machine to increase output
can expect profits from a particular plant over a 10 years period.

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 Once we have this kind of situation, the decision to invest becomes
complicated because profits received today are worth more than the profits
received in the future.
 This is so because the profits received today can be loaned at the market rate
of interest and more interest income can be generated from it.
 Therefore, in making investment decisions managers cannot just add profits
received for the various years and compare total profits with the cost of
investment.

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INVESTMENT CRITERIA: THE DECISION TO INVEST

 we can say that the decision to invest depends on three related elements.
These are:

 The expected income flow from the capital good in question;

 The purchase price of that good (cost of the investment project); and

The market rate of the return from the project or sale of the products,
which in turn depends on the market demand for the product

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 Example: Given the present value of stream of returns and the required
amount of money for the investment by different parties (A, B, C, D and E)
as follows,
 decide whether each party has to make the investment or not if we consider the
profit motive of investment.

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 Table 17. Decision of investment

Present value of the The amount of money Decision whether to

Investing
estimated returns from the required for the investment invest or not.
parties
investment (in Birr) (in Birr)
A 8,000 10,000 A
B 80,000 70,000 B
C 6,000 6,000 C
D 45,000 40,000 D
E 70,000 100,000 E

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SOLUTION

a. For the first party ‘A’, since the PV of the return from the investment is less than the
amount of money required, which is the cost of the investment (8,000 < 10,000), it is
proper not to invest.
b. For party ‘B’ since the present value of the benefit or the return is larger than the
cost (80,000 > 70,000), it is preferable to invest the resource or the money.
c. For party ‘C’, since both the present value of the return and the cost are equal (6,000
= 6,000), it is the same for the party to invest or not.
 From the point of view of producers, it may be advisable to invest with the
argument that the party will accumulate experience
 From the point of view of national economy it is better not to invest and rather to
provide the fund for some other alternative investments.
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d. For party ‘D’, since the present value of the return is greater than the cost
(45,000 > 40,000) it is better to invest the money.
e. For party ‘E’, the present value of the benefit of the investment is highly
smaller than the cost for the investment (70,000 < 100,000).
 Therefore, it is better not to invest; rather it is better to save the money to
provide fund for other investment activities.

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B. NON-PROFIT MOTIVES

 People, NGOs and governments participate in investment practices for non-

profit motives.
 The most important non-profit motive is the welfare reason or humanitarian
issues.
 Individuals and NGOs spend their resources on investment to benefit a
community from the return from the investments.
 There is national or political obligation on the government of a country to
spend on some investment activities in providing the society with some basic
infrastructure such as road, schools and health infrastructures. given by:
 GDP = C + I + G + X – M or Y = C + I + G + X – M or
 GDP = C + I + G + NX
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CROWDING OUT EFFECT

 The negative effect of this government investment activity on the overall

level of investment called crowding out effect.
 Crowding effect represents the case where the government action such as
fiscal policy or government investment activity itself reduces the
investment in the private sector.
 For instance an increase in government expenditure on investment or
some other activities reduces the government saving.
 This increases interest rate and as a result, investment declines as
borrowing become expensive.

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1.3. Some determinants of investment in less developed countries

 Investment in developed country is a function of profit and interest rate = f (τ, i).
 However, there are other several determinants of investment in developing
countries.
 Some of these factors are
 fiscal policy, exchange rate policy, trade policy, level of financial deepening
(financial intermediation) and External debt.
 But since they depend on their own market these impacts are less in developed
countries.

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a. Inflation

 Inflation cause loss of confidence in currency and lead to capital flight.

 Inflation leads to an increase in interest rate which means higher capital price
(expensive capital) which again discourages investment.
b. Fiscal Policy
 The major components of fiscal policies are taxation and government
expenditure.
 Tax affects the investment through two channels:
 Direct and indirect channels.

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 The direct channel is that a reduced tax increases the profit.
 Higher tax indirectly encourages investment as it increases the
government saving which in turn make the loan cheaper for better
investment and vice-versa.
 Increased government expenditure leads to an increased interest rate,
which has a crowd out effect on private investment.
 And this pushes the interest rate up and reduces private investment.

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C. EXCHANGE RATE POLICY

 One of the major policy instruments in relation to exchange rate policy is

devaluation.
 Devaluation has two major distinct implications :
1) If our target is domestic market, import becomes expensive. This implies that
cost of production increases and investment declines.
 So, finally this discourages investment in domestic market.
2) If our target is foreign market we can’t know the effect on cost of predation and
on investment.
 As this increases market size, it may encourage investment

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D. TRADE POLICY

 There are two major types of trade policy inward looking (called import
substitution policy) and outward looking (export promotion policy).
Inward looking (import substitution policy)
 Inward looking policy may be protecting investors from stiff competition of
world producers.
 If a government gives incentives for investors for definite time (protects
for definite time) it encourage investment.
 However, if the protection is for indefinite time it may reduce efficiency of
domestic producers and so discourage investment

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Outward looking ( export promotion)
 There is always reciprocity (retaliation) in international trade.
 This means the country imposes low tariff. If the firm is competitive at
initial stages, a decrease in tariff (low tariff in importing country) increase
profit and this in turn initiate or encourage investment.
 However, for uncompetitive firm a decrease in import tariff means cheap
imports which crowds out the domestic ones and discourages
investment.

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E. THE IMPACT OF GOVERNMENT DEBT ON INVESTMENT

 The government is overburdened due to excess debt. Excess debt is a

situation when government spends more than the income.
 Generally negatively affects investment in two ways.
Through debt financing/ Debt servicing
 During the debt period, there is always amortization and interest payment.
This makes financial resource unavailable for investment.

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Through debt stock
 Under high debt stock, investors expect higher tax by government in order to
finance the debt in future (to pay back the debt).
 As it is known that higher taxes discourage investment, the investors may not
come forward to invest.
 A country with high debt stock is risky to invest in. Foreign investors are
reluctant to do which in turn leads to lower overall investment.
 Moreover, if a country has high debt stock, its credit worthiness would diminish
(lose credibility) in international financial market.
 This implies that there will be shortage of foreign exchange loans for new
investment.
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TYPES OF INVESTMENT

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 THREE MAIN TYPES OF INVESTMENT

1. Business Fixed Investment (BFI)

 It means investment in the machines, tools and equipment that
businessmen buy for use in further production of goods and services.
 The stock of these machines or plant equipment etc. represents fixed
capital.
 The term ‘fixed’ in it implies that expenditure made on the machines,
equipment etc. continues to be used for production for a relatively long
time.

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ACCORDING TO KEYNES, BFI IS DETERMINED BY

(a) Expected rate of profit which he calls marginal efficiency of capital

(b) Rate of interest.
 Since rate of interest in the short run is relatively sticky, it is changes in
expectations about earning profits in future that cause fluctuations in
business fixed investment.

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ACCORDING TO THE NEOCLASSICAL THEORY, BFI IS
DETERMINED BY:

(a) Marginal product of capital

(b) User’s cost of capital.

 The user’s cost of capital merely depends on the price of capital goods, the
interest rate and the depreciation rate.

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2. RESIDENTIAL INVESTMENT (RI)

 It refers to the expenditure which people make on constructing or buying

new houses or dwelling apartments for the purpose of living or renting out
to others.
 Two important features of RI are worth noting.
 First, since the average life of a housing unit is of 40 to 50 years, the stock
of existing housing units at a point of time is very large as compared to the
new residential investment in a year.
 Second, there is well developed resale market for housing units so that
people who construct or own them can sell them in this secondary market.

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RI DEPENDS ON MANY FACTORS;

 Firstly, RI depends on price of existing housing units.

 The higher the price of existing units, the higher will be investment in
constructing and buying new housing units.
 Secondly, in the long run demand for housing is determined by rate of
population growth and formation of new households.
 The higher rate of population growth will lead to the increase in demand
for housing units.

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 Thirdly, Demand for RI Income is determined by the level of income.
 Since level of income over time fluctuates a good deal, there is strong
cyclical pattern of investment in residential construction.
 Fourthly, interest is another important factor that determines demand for
dwelling units.
 Most houses, especially in cities, are purchased by borrowing funds from
banks for a long time, say 20 to 25 years.

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3. INVENTORY INVESTMENT (InvI)

 The difference between goods produced (production) and goods sold (

sales) in a given year is called InvI.
 In other words, InvI is the change in the stocks of materials, works in
process, and finished goods within a firm, industry, or entire economy over
a specified period of time.
 Firms hold inventories of raw materials, semi-finished goods to be
processed into final goods.
 The firms also hold inventories of finished goods to be sold shortly.
 The change in the inventories or stocks of these goods with the firms is
called inventory investment.

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 The inventory investment of raw materials and goods is determined by on
the level of output which a firm plans to produce.
 An important model that explains the inventories of raw materials and
goods is the accelerator model.
 According to the accelerator model, the firms hold the total stock of
inventories of raw materials and goods that is proportional to their level of
output.

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Theories of Investment

37
 There are several theories, which try to explain the
investment and its determinant factors
 These theories of investment are
 Keynesian marginal efficiency of capital (MEC),
 Internal fund theory of investment;
 Accelerator theory of investment;
 Tobin q – theory of investment;
 Neo-classical theory of investment; and
 Inventory investment

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Keynesian Marginal Efficiency of Capital (MEC)

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 Keynesian marginal efficiency of capital (MEC) is an
alternative theory in making investment decision under profit
oriented investment motive.
 In this approach, the comparison is between marginal
efficiency of capital (r) and market rate of interest (i).
 Marginal efficiency of capital (r) is
 The rate of interest, which equates the cost of the project
and the discounted value of the future income stream
associated with the project.
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 To calculate the marginal efficiency of capital (r),
 we obtain the estimates of the cost of the project (C) and
 the future income stream associated with the projects,
P 1, P 2… P n.
 Where the subscripts: 1, 2, 3…..n. represent the years (from
now) in which the returns are received.
 These values are substituted into the general formula of
discounting process.
P1 P2 P3 Pn
C    ......  ......................................... 7
(1  r ) (1  r ) (1  r )
1 2 3
(1  r ) n

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 P1 P2 P3 Pn
C    ......  ......................................... 7
(1  r )1 (1  r ) 2 (1  r ) 3 (1  r ) n

 Then investor must compare it with the market rate of interest

(i).
 If the marginal efficiency of investment (r) is less than the
market rate of interest (i), the project is not profitable.
 i.e. The investor can be better off by simply lending or saving at
market rate of interest (i) rather than investing.
 This is because the lower value of marginal efficiency of
investment (r) measures the rate of return on the money used in
the investment. 42
 If the marginal efficiency of investment (r) is greater than the
market rate of interest (i),
 the project is profitable.

 This means that the return on the money used for investment
given by the marginal efficiency of investment (r) is
 larger if we put or use the money for the investment than
the return on it if we save or lend at market interest rate
(i).
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 Generally, From the point of view of profit oriented private
or government investment, it is suggested by this theory that
 investment resource or money is better used for
investment activity than to save or to lend at market
interest rate
 if the marginal efficiency of investment (r) is greater
than the market interest rate.
 This implies that the capital or the money will be more
efficient at margin if it is invested than if it is saved or lent at
market or banks interest rate. 44
 In the investment decision-making process, the market rate
of interest plays a crucial role.
 If the rate of interest is very high, then it may make
investment projects very expensive and unprofitable.
 This is because the marginal efficiency of capital is less
than the cost of the investment,
 which is the market interest rate.
 If market rate is low then it may make some previously
unprofitable projects as profitable because this is equivalent
to lowering the cost of investment.
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Accelerator Theory of Investment

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 Acceleration principle: is the relationship between the
change in the level of output and the volume of investment
 i.e. Addition to the capital good through the investment is
intended to accelerate or add to the output of the existing
one.
 So, the capital-output ratio is known as accelerator.

 This theory assumes that a particular amount of capital stock

is necessary to produce a given amount of output.

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 Example, if a capital stock of 500 birr is needed to produce
100 birr of output and if this keeps true over periods and
different level of capital,
 then we can say that there is a fixed relationship between
the capital stock and output.
 Let us assume that the ratio is given by a constant lamda
‘λ’,
 we canKexplain the relation with the following equations:
   K t  Yt
t
................................................. 8
Yt

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 Where, λ is the ratio of capital (Kt) in time period ‘t’ to the
output ‘Y’ in time period ‘t’.
 If λ is constant, the same relationship is true for the
previous year hence we can write the same relationship as
follows:
K t 1  Yt 1 ........................................ .............. 9

 By subtracting equation (9) from equation (8), we get:

K t  K t 1   (Yt  Yt 1 ) .............................. 10

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 The expression Kt - Kt-1 is the difference between capital
stock in time period ‘t’ and the capital stock in time period ‘t-
1’
 It is known as net investment.
 Net investment is equal to:
 the capital output ratio multiplied by the difference in
the output
 By definition, netininvestment
the two periods.
is equal to the gross investment
(I) minus capital consumption allowance or depreciation (D).

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 This can be incorporated in our equation as follows:

I t  D   (Yt  Yt 1 )  Y ................................. 11

 Equation (11) gives the expression that net investment

equals the accelerator coefficient (λ) multiplied by the
change in output

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 In other words, investment is a function of output.
 If output increases, the net investment also increases.
 If in an economy a capital stock of 500 birr is needed to
produce 100 birr of output,
 then the value of λ is 5.
 If aggregate demand is 100 birr worth of output, then
investment should be 500 birr.
 This means that if aggregate demand is constant then
 net investment is zero.

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 Because net investment is given as follows:
I t  D   (Yt  Yt 1 )  Y

 However, the aggregate demand is constant means

Yt and Yt-1 are equal and Yt -Yt-1 = 0.
I t  D   (Yt  Yt 1 )  Y   (0)  I t - D  0

Net investment = 0

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Example
Suppose aggregate demand increases from 100 to 105 Birr
worth of output, keeping the accelerator coefficient value 5,
 What is the net investment change in capital stock
required?
 What is new capital stock or capital stock of the
economy?

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Solution
The aggregate demand increases from 100 to 105 Birr worth of
output, and
then the investment need is equal to (5x5=25) obtained as
follows:
I t  D   (Yt  Yt 1 )  Y = 5(105 - 100) = 5(5) = 25

 The change in capital is 25 and

 the new capital stock is Kt + Kt –1 = 500 + 25 = 525
 Thus, the capital stock of the economy must be 525 Birr. 55
Limitations of the theory
1. The theory explains net investment but not gross investment
because for the determination of aggregate demand gross
investment is the relevant concept.
2. The theory assumes that a discrepancy between actual and
desired capital stocks is eliminated in a single period, which may
not be true.
 That means there may always be deviation between the desired
level of capital and the actual level

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3. Third, this theory assumes that there is a fixed relationship
between capital and output given by the constant value λ.
 However, in real situation there is possibility of substituting
capital to labour within a limited range.
 If this concept of substitution is true then the concept of fixed
capital – output ratio is not valid

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Neo-classical Theory of Investment

58
 According to neo-classical theory of investment, investment
is based on benefit and cost of the investment activity to a
firm or firms.
 This theory assumes that firms borrow capital at a rate (R)
from the owner of the capital and sell its product at price P

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 The cost of capital is equal to (R/P).
 Real cost (R/P) has the shape of normal cost curves function,
which is increasing or upward sloping.
 In terms of benefit, we can get the productivity of the capital,
 which goes down with more investment at margin.
 Real benefit is measured in terms of marginal productivity of
capital (MPK).
 The curve measuring this benefit is down ward sloping
 since marginal product of a factor of production including
capital declines as the level of employment of the factor
increases. 60
 The level of investment has to keep on increasing

 as long as the benefit of doing it is greater than the cost of

doing so or the cost of the investment activity.
 This implies that the investment level should increase up to the
level where
 the real cost of investment equals its marginal benefit given
by marginal product of the investment good or capital.

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 This is represented by the point of intersection between the cost
(R/P) curve and the benefit (MPK) curve given by point ‘e’ in the
following figure (Figure 3.5).
 The firm employ capital up to ‘e’

 where R/P = MPK  R = P (MPK).

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 Here marginal benefit is equal to the marginal cost of production
 The Figure
firms 3.5: Neo invest
should -classical
upoptimal
to the investment
level whenlevel
the marginal
 However, at point “a” the investors gain more by paying less
benefit is exactly equal to the marginal cost of production. (This
and there is justification to increase investment.
is achieved at point ‘e’)


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Finally, this theory implies also that it is better to focus on
factors that affect benefit of investors such as
 improving capital efficiency,
 lowering taxes on the investment products and
 keeping lower market interest rate.

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