Investment,Types of investment, determinants of investment

Meaning of Investment

In simple terms, Investment refers to purchase of financial assets. While Investment Goods are those goods, which are used for further production.

Investment implies the production of new capital goods, plants and equipments. John Keynes refers investment as real investment and not financial investment.
Investment is a conscious act of an individual or any entity that involves deployment of money (cash) in securities or assets issued by any financial institution with a view to obtain the target returns over a specified period of time.

Investment spending is an injection into the circular flow of income. Firms invest for two primary reasons:

1. Firstly, investment may be required to replace worn out, or failing machinery, equipment, or buildings. This is referred to as capital consumption, and arises from the continuous depreciation of fixed capital assets.
2. Secondly, investment may be undertaken to purchase new machinery, equipment, or buildings in order to increase productive capacity. This will reduce long-term costs, increase competitiveness, and raise profits.

Gross investment includes both types of investment spending, but net investment only measures new assets rather than replacement assets. This relationship is expressed in the following equation:

Net investment = gross investment – depreciation

For example, if an airline replaces five worn out aircraft with identical new aircraft, and purchases two more aircraft in order to be able to fly to more destinations, then gross investment is seven, replacement investment is five, and net investment is two.

In economic theory, net investment carries more significance, as it provides the basis for economic growth.

Target returns on an investment include:

1. Increase in the value of the securities or asset, and/or
2. Regular income must be available from the securities or asset.

Types of Investment

Different types or kinds of investment are discussed in the following points.

1. Autonomous Investment

Investment which does not change with the changes in income level, is called as Autonomous or Government Investment.

Autonomous Investment remains constant irrespective of income level. Which means even if the income is low, the autonomous, Investment remains the same. It refers to the investment made on houses, roads, public buildings and other parts of Infrastructure. The Government normally makes such a type of investment.

2. Induced Investment

Investment which changes with the changes in the income level, is called as Induced Investment.

Induced Investment is positively related to the income level. That is, at high levels of income entrepreneurs are induced to invest more and vice-versa. At a high level of income, Consumption expenditure increases this leads to an increase in investment of capital goods, in order to produce more consumer goods.

3. Financial Investment

Investment made in buying financial instruments such as new shares, bonds, securities, etc. is considered as a Financial Investment.

However, the money used for purchasing existing financial instruments such as old bonds, old shares, etc., cannot be considered as financial investment. It is a mere transfer of a financial asset from one individual to another. In financial investment, money invested for buying of new shares and bonds as well as debentures have a positive impact on employment level, production and economic growth.

4. Real Investment

Investment made in new plant and equipment, construction of public utilities like schools, roads and railways, etc., is considered as Real Investment.

Real investment in new machine tools, plant and equipments purchased, factory buildings, etc. increases employment, production and economic growth of the nation. Thus real investment has a direct impact on employment generation, economic growth, etc.

5. Planned Investment

Investment made with a plan in several sectors of the economy with specific objectives is called as Planned or Intended Investment.

Planned Investment can also be called as Intended Investment because an investor while making investment make a concrete plan of his investment.

6. Unplanned Investment

Investment done without any planning is called as an Unplanned or Unintended Investment.

In unplanned type of investment, investors make investment randomly without making any concrete plans. Hence it can also be called as Unintended Investment. Under this type of investment, the investor may not consider the specific objectives while making an investment decision.

7. Gross Investment

Gross Investment means the total amount of money spent for creation of new capital assets like Plant and Machinery, Factory Building, etc.

It is the total expenditure made on new capital assets in a period.

8. Net Investment

Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of time, usually a year.

It must be noted that a part of the investment is meant for depreciation of the capital asset or for replacing a worn-out capital asset. Hence it must be deducted to arrive at net investment.

The determinants of investment

The level of investment in an economy tends to vary by a greater extent than other components of aggregate demand. This is because the underlying determinants also have a tendency to change.

The main determinants of investment are:

The expected return on the investment

Investment is a sacrifice, which involves taking  risks. This means that businesses, entrepreneurs, and capital owners will require a return on their investment in order to cover this risk, and earn a reward. In terms of the whole economy, the amount of business profits is a good indication of the potential reward for investment.

Business confidence

Similarly, changes in business confidence can have a considerable influence on investment decisions. Uncertainty about the future can reduce confidence, and means that firms may postpone their investment decisions until confidence returns.

Changes in national income

Changes in national income create an accelerator effect. Economic theory suggests that, at the macro-economic level, small changes in national income can trigger much larger changes in investment levels.

Interest rates

Investment is inversely related to interest rates, which are the cost of borrowing and the reward to lending. Investment is inversely related to interest rates for two main reasons.

1. Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a rise in interest rates increases the return on funds deposited in an interest-bearing account, or from making a loan, which reduces the attractiveness of investment relative to lending. Hence, investment decisions may be postponed until interest rates return to lower levels.
2. Secondly, if interest rates rise, firms may anticipate that consumers will reduce their spending, and the benefit of investing will be lost. Investing to expand requires that consumers at least maintain their current spending. Therefore, a predicted fall is likely to discourage firms from investing and force them to postpone their investment decisions.

General expectations

Because investment is a high-risk activity, general expectations about the future will influence a firm’s investment appraisal and eventual decision-making. Any indication of a downturn in the economy, a possible change of government, war or a rise in oil or other commodity prices may reduce the expected benefit or increase the expected cost of investment.

Corporation tax

Firms pay corporation tax on their profits, so a reduction in tax increases the profits they retain after tax is paid, and this acts as an incentive to invest. In 2009, the rate for small businesses was 21%, and the main rate for profits over £1.5m was 28%.

The level of savings

Household and corporate savings provides a flow of funds into the financial sector, which means that funds are available for investment. Increased saving may reduce interest rates and stimulate corporate borrowing and investment.

The accelerator effect

Small changes in household income and spending can trigger much larger changes in investment. This is because firms often expect new sales and orders  to be sustained into the long run, and purchase larger quantities of capital goods than they need in the short run.

In addition, machinery is generally indivisible which means it cannot be broken into small amounts and bought separately. Even small increases in demand can trigger the need to buy complete new machines or build entirely new factories and premises, even though the increase in demand may be relatively small.

The combined effect of these two principles creates what is called the accelerator effect. For example, if in a given year national income rises by £20b, and investment rises by £40b, the value of the accelerator is 2.

Showing the effects of an increase in capital investment

The initial impact of investment is on the AD curve, which shifts to the right as investment (I) is a component of AD, show shown below:

In the long run, the investment will increase the economy's capacity to produce, which shifts the LRAS curve to the right. Finally, it is likely that production costs will fall as new technology increases efficiency and reduces average costs. This means that the SRAS curve shifts to the right. The combined effects are that the economy grows, both in terms of potential output and actual output, without inflationary pressure.

Recent changes in UK investment

After over a decade of continuous growth, gross investment fell during 2008 and 2009. Investment grew again during 2010, but fell back between 2011 and 2012, indicating the continuing negative impact of the recession on the availability of capital, and on business confidence.