Investments
Topic Twenty-Two

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Difference between Capital and Investment

There is s difference between investments and capital. In the study of economics, investment has a different definition from that of the study of finance. In everyday life, investment means the buying of shares, stocks, bonds and securities on a secondary market such as the stock exchange. However, this is not real investment. This is so because it is simply a transfer of existing assets. This is why it is called financial investment which does not affect aggregate spending. These are really just transfer transactions. Real income is not increased as a result of these financial investments

Investments lead to an increase in the levels of income and production by increasing the production and purchase of capital goods. Investment thus includes new plant and equipment, construction of roads, buildings, net foreign investment, inventories and stocks and shares only of new companies. Capital, on the other hand, refers to real assets like factories, plants, equipment, and inventories of finished and semi-finished goods that already exist. Capital refers to items that are already there but investments refer to the additions to capital.

Accelerator Effect and Investment – Capital to Output Ratio

The accelerator effect relates to the effect that changes in output have on the levels of investments. The basic accelerator model suggests that capital investment is a function of or depends on output. This will mean that when there is an increase in output, we can expect investments to increase. On the other hand, if there is a fall in output, we can expect the level of investments to decrease. Therefore, a fall in the growth rate can lead to lower investment. This suggests the accelerator effect can explain how an economic slowdown leads to a recession.

The accelerator model implies that the business cycle can be volatile. The accelerator can be represented as:

K = f(AD) K = Capital Stock
AD = National Output
f = relationship between capital and output.

Example:

If there is an increase in output or AD by TT$1.0 million and f is 3, then investment will be TT$3.0 million which is TT$1.0 million times f which is 3.

The Marginal Efficiency of Capital

Marginal efficiency of investment, in economics, is the expected rates of return on investment over a stated period of time. A comparison of these rates with the going rate of interest may be used to indicate the profitability of investment. The rate of return is computed as the rate at which the expected stream of future earnings from an investment project must be discounted to make their present value equal to the cost of the project. Logically, investment would be undertaken as long as the marginal efficiency of each additional investment exceeded the interest rate. If the interest rate were higher, investment would be unprofitable because the cost of borrowing the necessary funds would exceed the returns on the investment.

This theory suggests investment will be influenced by: the marginal efficiency of investments and the interest rates. A lower interest rate makes investment relatively more attractive. If interest rates were 4 percent, then firms would need an expected rate of return of at least 4 percent from their investment to justify investment.

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