CHAPTER 5  The relationship between the

national income and induced

INVESTMENT FUNCTION
investment is positive:
Investment Function Discussions  Decreases in national
income leads to decrease in
1. describe investment as a determinant induced investment and vice
of income versa
2. discuss the acceleration principle  Induced investment is
3. discuss the relationship between income elastic.
investment and output
4. name the determinants of savings
5. name the investment demand
INVESTMENT FUNCTION
determinants
6. describe how investment demand- The investment function refers to
supply is being affected by foreign investment interest rate relationship.
borrowings There is a functional and inverse relationship
between rate of interest and investment.
The investment function slopes
INVESTMENT as DETERMINANT OF
downward.
INCOME

INVESTMENT AS A DETERMINANT OF
What is investment?
INCOME
An investment is an asset or item
acquired with the goal of generating
income. It involves putting capital to use Investment leads to increase in the
today in order to increase its value over time. levels of income and production by
increasing the production and purchase of
When an individual purchases a good
capital goods.
as an investment, the intent is not to
consume the good but rather to use it in the Investment thus includes new plant
future to create wealth. and equipment, construction of public
works (like dams, roads, buildings), net
foreign investment, inventories and
TWO (2) types of Investment stocks, and shares of new companies.

1. Autonomous Investment
2. Induced Investment
BASIC CONCEPT OF INVESTMENT
The investment expenditure is
AUTONOMOUS INVESTMENT
capital spending mainly derived not for
 Investment that is not current income and consumption but
dependent on the national from accumulated savings and other
income sources external to the circular flow.
 Mainly done with the welfare
Current business income serves
motive and not for making
current business needs and the surplus may
profits.
not suffice to finance even a fraction of
Examples: Construction of Road, Bridges, investment spending as on new equipment.
School, Charitable Houses
 Not affected by rise in raw
Basic Concept of Investment
materials or wages of workers
 Essential to development of 1. A business may borrow a savings of
nation and out of depression. the economy which households
likewise do.
2. Investment increases the capital
INDUCED INVESTMENT stock and the expenditures for which
generate income as inflow to the
 Induced investment is profit system.
motivated 3. Investment expenditure is simply
 It is related to the changes of assumed as an exogenous
national income.
 component of National Income, an MPC= ∆C/∆Y
external factors affecting income.
= P 4,000/P 5,000
= 0.8
Basic Concept of Investment
The following equation illustrate how the
1. Investment spending – is a long- investment factor is incorporated in the
term consumption and not a income function with the multiplier process:
monopoly of business but extends
∆y = IM
to households and the government.
∆y = I +∆C
since initially:
2. Households – spends on fixed y=C
asset which are yet to be consumed therefore:
gradually over a long period. y = C+∆C+I
y = C+I
3. Government – invests when it where:
spends on social overhead y= Income
facilities to provide a stream of social C= Consumption
benefits during a long road facilities. I= Investment
However, the government M= Multiplier
investment expenditures are ∆= Change
classified under the government
spending which is another type of
income- generating inflow. The equations imply that investment is
directly proportional to income.

Distinction between CONSUMPTION and

INVESTMENT EXPENDITURES THE RELATIONSHIP BETWEEN
INVESTMENT AND OUTPUT
Consumption expenditure is
spending on current consumption of non-
durable goods BASIC CONCEPTS
Investment expenditure is Business and household
spending on capital goods which are investments tend to increase the economy's
repeatedly used and gradually consumed stock of capital and total output; whereas
over a long period as durable goods. depreciation has the opposite effect.
Current depreciation decreases total
MARGINAL PROPENSITY TO CONSUME output in the short-run.
Current investment only yields
output in the long-run for two reasons. First,
Marginal Propensity to Consume (MPC) is the process of setting up and even testing
proportion of an increase in income that gets the capital base creates operational lags.
spent on the consumption. Second, every phase in setting up a capital
base may not be capable of independent
MPC= ∆C/∆Y utilization until the completion of other
where: phases.
∆C= the change in consumption
∆Y= the change in income
INVESTMENT AND THE STOCK
ADJUSTMENT PROCESS
MARGINAL PROPENSITY TO CONSUME
Investment patterns can determine
Example: Suppose you receive a P 5,000 trends in the capital stock and production
bonus on top of your normal annual level over a long period. Investment
earnings. You suddenly have P 5,000 more increases the stock since additional capacity
in income than you did before. If you decide brings additional production capacity.
to spend P 4,000 on a new cellphone and
The following framework illustrates
save the remaining P 1,000, your marginal
investment – output relationship assuming a
propensity to consume will be 0.8.
short-run time frame, no investment-
Solution: production time lag, and constant capital
output ratio:
 Kf = (Ki – D + I)
Yf = (Yi - ∆yd + ∆yi) = a(Ki – D + I)

where:
SAVINGS AS A SOURCE OF
Kf = stock of capital after depreciation INVESTMENT
and investment  The initial income that an investment
Ki = initial stock of capital expenditure generates is equal to
itself.
D = depreciation
 Additional income comes in the form
I = investment of consumption and deducting total
Yi = initial output from the capital consumption expenditure from total
income yields this investment inflow.
stock  The difference is also equal to total
Yf = total output from the capital stock savings since the investment inflow is
fully siphoned from the system as
after depreciation and investment
savings outflow at equilibrium income.
∆yd = change in total output because
of depreciation
SAVINGS-INVESTMENT EQUILIBRIUM
∆yi = change on total output because
of investment
a = output-capital ratio (Y/K) Going back to the new income equation.

furthermore: Y=C+I
*Net change in capital stock = (-D+I) Y-C = I
*Net change in output = (-∆yd + ∆yi)
S=I

SAVINGS AS A SOURCE OF
INVESTMENT The savings-investment equilibrium
further implies that increasing, decreasing or
Savings is the unspent portion of maintaining the level of investment
income during the period intended for expenditure will respectively increase,
spending. It is a residual of income which decrease, or maintain the level of income
accumulates into a stock for future use and, and savings assuming ceteris paribus.
therefore, postpones current consumption. Hence, investment expenditure is equal to
However, savings yet to be spent in savings at any income level.
the long-run should be of particular interest
to investment since it takes time for the latter
to return the savings borrowed from the DETERMINANTS OF SAVINGS
economy because of the long-term usage of PRICE LEVEL
capital. It is the savings of the economy
that affects the income multiplier. According to Investopedia, PRICE
LEVEL is the average of current prices
Savings of the economy can be across the entire spectrum of goods and
simply expressed as follows assuming that it services produced in the economy. In more
is the only determinant of the multiplier: general terms, price level refers to the price
or cost of a good, service. or security in the
economy.
S=Y–C In economics, price levels are a key
Where: indicator and are closely watched by
economists. They play an important role in
S = savings the purchasing power of consumers as well
Y = income as the sale of goods and services. It also
plays an important part in the supply-
C = consumption demand chain.
 2. Capital-shallowing effect. Rapid
population growth lowers the ratio of
capital to labor since there is nothing
about population growth per se that
increases the amount of savings.

POPULATION GROWTH 3. Investment-diversion effect. Rapid

A high growth of population has an population growth generates a
adverse effect on the per capital income strong demand for government
which causes an adverse effect on the expenditures in areas such as
saving-income ratio. education and health, thereby
diverting funds from relatively more
The amount of overall saving in the productive, growth-oriented public
economy is also influenced by the and private investment.
population's age distribution. The dissaving
of elderly and retired people and the saving
of the younger group determine total LEVEL OF INCOME
personal saving. When the positive saving
of the young people is only offset by the As Keynes stresses, saving is
negative saving of the old to sustain their basically a function of income. Saving
consumption expenses, the community's increases with income. Of course, there can
aggregate saving would be zero. hardly be a proportionate relationship
between the size of income and savings, but
If a society has a large proportion of empirical evidence has proved that there is a
young people in relation to old people, net marked correlation between the two.
aggregate saving will be positive. Thus,
the aggregate saving ratio in a community However, the amount of personal
tends to vary with the age structure of its savings depends primarily on the disposable
population, even with constant per capita income. Thus, the saving income ratio tends
income. It follows thus that when the to rise with an increase in income. It has
population is stable in all respects, net been observed that the marginal
saving will rise with the increasing per capita propensity to save tends to be high in high-
income in an economy. income group sectors of community. Indeed,
in developed countries, where per capita
It is widely recognized that income is high, the saving- income ratio is
population growth can have two also high.
conflicting effects on savings. It reduces
savings as it leads to more dependent
children, but if balanced it can also increase
CONCEPTS OF INCOME
savings by increasing the number entering
the working part of the life cycle and hence  Absolute Income
the number of potential savers.  Relative Income
 Permanent Income

POPULATION GROWTH
Economists Ansley J. Coale and 1. Absolute Income
Edgar M. Hoover considered three (3) According to Keynes, saving is a
adverse impacts of population growth on function of the absolute level of income.
savings and capital formation. In the absence of change, an increase in
absolute income results in a rise in the
percentage of that income that is saved.
THREE (3) IMPACTS OF POPULATION
GROWTH ON SAVINGS AND CAPITAL 2. Relative Income
FORMATION According to Duesenberry, the
1. Age-dependency effect. Rapid proportion of income a person
population growth leads to a high consumes depends on their relative
ratio of children to working adults income, that is, their percentage in the
and diverts household income from total distribution of income. Therefore,
saving toward consumption. with the increase in absolute income and
the improvement of the relative position in
 the distribution of income, the per capita and consumer behaviors due to changes in
consumption ratio will decrease in a given goods and services.
period, or the saving ratio will be higher.
Many economic factors affect the
However, if an individual's relative
demand for goods and services, those
position on the income scale remains the
factors are called determinants.
same, his share of consumption and
saving will remain the same even though
his absolute income has increased.

3. Permanent Income
INTEREST RATE
According to Keynes, current
income determines current consumption
and saving. However, contemporary
economists such as Milton Friedman
have pointed out that expectations of
future income have a significant impact
on current consumption spending and
saving for a given income in society.
According to Friedman, the main
determinant of consumption and saving is
permanent income. Friedman states
that permanent income can be
interpreted as the average income
considered in perpetuity by the relevant
unit of consumption.
Investment demand is inversely
proportional to the interest rate level with
LEVEL OF INCOME other factors as constant (ceteris paribus)
resulting in an investment demand curve that
 According to Friedman, the actual or is downward sloping.
measured income (Ym) is composed
of permanent income (Yp) and
transitory income (Yt). Interest Rate
Thus, Ym= Yp+Yt
Three (3) possible explanations
which explains the interest rate's
 Similarly, actual measured downward sloping:
consumption (Cm) is said to be
composed of permanent consumption 1. One possible explanation for this
(Cp) and transitory consumption (Ct). shortrun relationship is that interest
Thus, Cm= Cp+Ct rate increases tends to squeeze profit
as a cost and, therefore, reduces the
number of investments with favorable
 It follows thus that actual measured
returns.
savings (Sm) are constituted by
2. Another explanation is lending one's
permanent saving (Sp) and transitory
own money to earn interest is an
savings (St).
alternative to business investment.
Thus: Sm = Sp+St 3. Third explanation is the influence of
the interest rate level on the
resource mix.
 Obviously, Sm = Ym – Cm or

Sm = (Yp+Y) – (Cp+Ct).
INNOVATION
Another long-run factor which can
INVESTMENT DEMAND DETERMINANTS shift the investment demand curve is
innovation.
Joseph Schumpeter- a noted
What is demand and determinants?
development economist in the contemporary
Demand is an economic principle times describes innovation as the
that explains the relationship between prices introduction of unfamiliar product and
untested technology, opening a country's nag-invest ang logictics facility ng additional
product to markets and sources or raw 5 truckings. The facility decided to increase
material not previously encountered; and the the investment in trucks because there is a
setting up of a new organization. multiple increase in income.
Innovation can create demand for Yf=(Yi - ∆yd+ ∆yi) a(Ki-D+I)
products including capital goods and usher
acceleration process between income and Total output from the Capital-Output ratio times
investment. Advances in computer capital after the quantity of initial
technology have encouraged massive depreciation and capital stock less
investments to computers. investment equals the depreciation add
quantity of initial output investment.
minus change in total
output because of
PROFIT depreciation plus
Profit is the basic reason why a change in total output
because of investment.
business invests and, therefore, profit rends
in the long-run.
This proves that "consumption has
Investments in the economy took a to keep on increasing in order for
sharp downturn when the economic crisis investment to stand still or to continue."
took its toll in 1984.
Weak demand and aggravated the
profit squeeze that discouraged investment
as primarily attributable.
Acceleration Principle
EXPECTATIONS The equation Yf=(Yi - ∆yd+ ∆yi) is equal to a(Ki-D+I)
Expectations, as defined by Oxford
Languages, is a strong belief that
something will happen of the case in the
future. In economics, expectations are the Depreciation was capital stock to be
forecasts made by the decision-makers of a depreciated when the output declines.
business about the future prices, sales,
incomes, taxes, and other key variables.
A businessman invests and expects a  The equation depicts that
certain level of profit given a certain influence investment will increase only if the
of the business environment. Mediocre rate of output increases.
businessman simply views the future as a  Investment in an economy depends
continuation of past trends. Perceptive not on the level of income but on how
investor - delves into underlying changes to fast output or the level of business
anticipate turning points in the business sales is rising or falling. To raise
environment and decides at present the investment, output not only has to
magnitude and type of investment he should grow, it has to grow by increasing
make. rate.

The Acceleration PRINCIPLE One of the qualifications that affects

the acceleration principle is the "lag".
This principle states that the level of
investments is a function of desired changes Time lags in investment.
in output. Investment lags behind the change in
income is planned investment for the given
period that is based on the actual change
between the current period, rather than the
Example:
forecast change between the given period.
A business cafe's decision to make a
An increase in the desired output
new investment on coffee machine depends
level creates lag between the desired and
on the increase in the rate of sales of output
actual level of capital stock, this lag induces
or the rate of demand for the coffee product.
investment, increases the capital stock and
Over the years mas tumataas ang boost in order to meet higher levels of
rate of sales sa e- commerce business kaya output.
 A decline in the desired output 1. Foreign borrowing gives a country
level decreases investment even to a level access to more money to invest. This
of zero if the actual stock of capital is more can help increase the returns or
than enough to meet declining output levels. allows to buy bigger investments,
such as properties.
Furthermore, investment spending
is now considered as exogenous variable
of income.
Investment spending may include
purchases such as machinery, land,
production inputs, or infrastructure.

INVESTMENT DEMAND – SUPPLY AND

FOREIGN BORROWINGS

Foreign debt refers to the money

that a government, an organization, or a
household borrows from the government
or private lenders of another country.
Foreign borrowings gradually risen in
recent years, thus, slowing economic growth,
especially in low-income countries, crippling
debt problems, and stock market instability.
Foreign debt can be a boon or a
bane for any economy. In the Philippines, it
has been both. As we all know, foreign
borrowings can be used to finance
infrastructure and social development
projects which can accelerate economic
development and improve people's lives.

In relation to investment demand-supply,

here are the negative effects of foreign
borrowings:

1. Growing levels of debt can

discourage foreign and private
investment due to concerns of
unsustainability and fear of default.
This will lead to lower demand of
investment in the country, thus,
negatively affecting the economy and
financial markets.

2. Excessive amounts of foreign debt

will hinder countries' capacity to invest
in their economic future, as their
limited revenue goes to servicing their
loans. This will decrease the supply
of investment in the country. thus,
limiting the economic activities.

Foreign borrowing has also positive impact

to the investment demand-supply of a
country.