Investment Functions Prof. Tarun Das

Economic Environment and Policy (EEP) Session-6 Investment Multiplier And Business Cycles Dr. Tarun Das, Professor, IILM

Prof. Tarun Das, IILM

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Contents of this presentation 1. Investment function, investment multiplier and accelerator 2. Numerical examples 3. Types of business cycles 4. Causes of business cycles 5. Macro variables and business cycles

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1.1 Investment Function and Accelerator 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 / ∆Yt Kt = w. Yt, where w = COR = ICOR It = Kt – kt-1 = w (Yt – Yt-1) = w ∆Yt The basic relationship between change of output and volume of investment is known as accelerator principle. The capital/output ratio w is known as the accelerator.

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1.2 Investment Multiplier Investment multiplier is the ratio of incremental income to incremental investment. Investment multiplier = ∆Yt / ∆It Yt = Ct + It = α + β Yt +It Or, Yt - β Yt = α + It Or. (1- β ) Yt= α + It Or, Yt = α / (1-β ) + 1/ (1-β ) It Investment multiplier = ∆Yt / ∆It = 1/ (1-β ) = 1/ (1-MPC) = 1/ MPS. Investment multiplier varies directly with MPC and inversely with MPS. Prof. Tarun Das, IILM

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2.1 Numerical Example: Multiplier Problem-1: Given consumption function C=50+0.75 Y or savings function S=-50+0.25 Y, Estimate investment multiplier. If investment rises by Rs.100 Crore, what is the increase of income? How is additional income distributed between savings and consumption? Answer: Here, MPC=0.75, MPS=0.25 Investment multiplier = 1/ (1-MPC) = 1/ MPS = 1/ 0.25 = 4. If investment rises by Rs.100 Crore, income rises by Rs.400 Crore. Then, consumption rises by MPC*Y = 0.75*400 = Rs.300 Crore and savings rises 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 of 36%, estimate ICOR. Assuming that ICOR declines by 5% due to increase of productivity, how much investment is required 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 of 10% = 3.8 * 10 = 38%.

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2.3 Equilibrium Income with government Problem-3: Let consumption depends on disposable income and consumption function is given by: C=50+0.75 (Y-T). Further assume that average tax rate is 20% and govt maintains a balanced budget. If domestic private investment equals Rs.100 Crore, find out equilibrium level of income, consumption, savings and taxes.

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2.4 Equilibrium Income with government

Answer:T = 0.2 * Y= govt expenditure (G) as govt 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+ 0.2Y as S=I=100. Or, Y= 150+0.8Y Or, Y-0.8Y = 150. OR, Y=150/0.2=750. T=0.2*750=150 =G C=50+0.75 (750-150) = 500 S=Y-C-T=750-500-150=100 Check: Y=C+S+T=500+100+150=750 Y=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-down movements in economic activity: such as real GDP, employment, profits etc. • Its timing is random, and to a large degree, unpredictable. • A business cycle is identified as a sequence 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 pace of economic activity); A recession occurs if a contraction is severe enough. A deep trough is called a slump or a depression. 2.Trough (The lower turning point of a business cycle, where a contraction turns into an expansion); 3.Expansion, Prosperity, Boom (A speedup in the pace of economic activity); 4.Peak (The upper turning of a business cycle, where an expansion turns into a contraction). Prof. Tarun Das, IILM

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3.3 Different phases of business cycles variable

Peak

Contraction Expansion

Trough

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3.4 Business Cycles are Irregular • In many ways, the term “business cycle” is misleading. • “Cycle” seems to imply that there is some regularity in the timing and duration of upswings and downswings in economic activity. • Most economists, however, do not think so. • For describing the swings in economic activity, therefore, many modern economists prefer the term “short-run economic or business fluctuations” to “business cycle.” Prof. Tarun Das, IILM

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• • • 1. 2. 3. 4.

3.5 Types of Business Cycles Main types of business cycles have been named after their exponents. The Kitchin inventory cycle (3–5 years) — after Joseph Kitchin, The Juglar fixed investment cycle (7–11 years) — after Clement Juglar, comprising four stages: expansion = rise in production and prices, and low interests rates. crisis = stock exchanges crash and several companies become bankrupt. recession = decrease in price and in output, high interests rates. recovery= stocks recover thanks to the fall in prices and incomes.

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3.6 Types of Business Cycles • The Kuznets infrastructural investment cycle (15–25 years) — after Simon Kuznets, Nobel Laureate, • The Kondratieff industrial wave or innovation cycle (45–60 years) — after Nikolai Kondratieff. • The Forrester generation cycles (200 years) - after Jay Wright Forrester. • The Toffler civilization cycles (10002000 years) - after Alvin Toffler.

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4.1 Business Cycle (BC) variables

• Business cycles are generally measured by movements or growth rates of real GDP, 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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4.2 Measurement of Business CyclesTrend in Real GDP in USA in 19552005

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4.3 Log Real GNP and Trend

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4.4 Deviations from Trends in Log GNP

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4.5 Figure depicts fluctuations in GNP and

consumption. Observe how peaks and troughs align and how upturns and downturns coincide.

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5.1 Causes of Business Cycles • Just as there is no regularity in the timing of business cycles, there is no reason why cycles should occur at all. • Business cycles occur due to some disturbances, which pull the economy above full employment or push it below. • Inflationary booms are generated by surges in private or public spending. • Similarly, a wave of optimism or feel good factors cause consumers to spend more than usual and firms to build up new capacities than necessary.

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5.2 Causes of Business Cycles • Recessions or depressions can be caused by the same forces working in reverse directions. • A substantial cut in government spending or a wave of pessimism among consumers and firms may cause the output of all types of goods and services to fall. • Another possible cause of recessions and booms is monetary policy. • A firm faced with high interest rates may decide to postpone building a new factory. • Households may be lured by cheap housing loans, and construction activities may boom. Prof. Tarun Das, IILM

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5.3 Political Theory of Business Cycles

• The partisan theory of business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. • Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high and hurts everybody. • The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A. Prof. Tarun Das, IILM

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6.1 Co-movement of variables Many economic indicators move together during business cycles. During an expansion, not only output rises, but also employment and profits rise. • Construction, retail and financial services also rise, and inflation may rise if the expansion is too brisk. • Conversely, during recession, outputs of goods and services falls, employment falls, construction falls, and prices of consumer goods and wages also fall. • Recession is a period when a broad range of economic indicators falls for a sustained period, roughly at least half a year. •

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6.2 Cyclical behavior of macro economic variables and BC indicators

According to Direction of change: variables

can be classified as procyclical, countercyclical or acyclical. • Procyclical- Variables have positive correlation. They usually increase during booms and decrease during recessions. Consumption, investment and employment are strongly procyclical. • Countercyclical- Variables have negative correlation. Unemployment is countercyclical. • Acyclical- Variables have zero correlation, implying no systematic relationship to the business cycle . capital stock is acyclical.

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6.3 Cyclical behavior of macro economic variables and BC indicators

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

Leading Indicator: which occurs ahead of the occurrence of business circle variable. Coincident Indicator: which move up and down along 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 Time of change occurrenc e Industrial output procyclical coincident Capacity utilization

procyclical

coincident

Employment

procyclical

coincident

Unemployment

countercyclica coincident l Inflation rate procyclical lagging Corporate coincident29 Prof. Tarun Das, IILM profits procyclical EEP Session-6

Thank you Have a Good Day

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