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12 The role of
Investment in
Profit
Generation
Chapter Outline

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Investment and profits Posted on Friday, July 27, 2012 by bill
12.1
Investment in a Capitalist Monetary Economy
In Chapter 5 National Income and Product Accounts, we learned that investment spending – or Gross fixed
capital expenditure – is a major component of aggregate demand. In Chapter 6 Sectoral Accounting, we noted
that investment formed one row in the Transactions matrix as did the term Profits.
In this Chapter, we tie those two aspects of business activity together.
Profits and investment spending are intrinsically linked in a Capitalist economy, which we described in Chapter
2. In this Chapter we examine the behaviour of private investment spending and seek to explain where profits
come from in a macroeconomic sense.
We prioritise a study of investment for three main reasons.

Fluctuations help to account for the business cycle. Movements in economic activity and
hence employment are strongly driven by fluctuations in private investment. The other main
components of aggregate demand being relatively stable.

Investment spending is an important determinant of total profits in the economy.

Investment spending can be significantly altered by government policy, which means that
policy can “manage” the economic cycle somewhat through its influence on private
investment growth.
Economists use the term investment differently to the common usage, which might include people placing their
saving in the form of financial assets, real estate and other speculative vehicles.
In the financial papers and reports you will often read or hear, for example, that “investors have become more
pessimistic” in relation to bond prices or other financial assets. Use of the term “investors” in this context if
different to the way we use it in macroeconomics.
Investment is defined in macroeconomics to be that spending which is devoted to increasing or maintaining the
stock of productive capital.
The capital stock is comprised of factories, machines, offices, and other durable products that are used up in the
production process, inventories and residential housing.
Investment spending is a flow of expenditure which adds to the stock of productive capital.
The Volatility of Investment
Table 12.1 shows Total Investment ratios for selected countries from 2000 with decade averages provided for
the 1980s, 1990s and 2000s. CV is the coefficient of variation which is defined as the ratio of the standard
deviation to the mean and provides what statisticians call a normalised measure of dispersion. The coefficient of
variation allows one to compare dispersion across very different samples without recourse to information about
the underlying average.
Except for Australia, the investment ratios have been falling. For Germany, Japan and the United States, the
investment ratio has also become more volatile.
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Table 12.1
Total investment ratios for selected countries, per cent of GDP
Year
Australia
France
Germany
Japan
United
Kingdom
United
States
2000
24.7
19.9
22.3
25.1
17.7
20.9
2001
23.2
19.6
20.3
24.3
17.4
19.3
2002
24.9
18.6
18.1
22.5
17.1
18.7
2003
26.6
18.5
17.9
22.4
16.8
18.7
2004
27.2
19.1
17.6
22.5
17.1
19.7
2005
28.0
19.9
17.3
22.5
17.1
20.3
2006
27.3
20.8
18.1
22.7
17.5
20.6
2007
28.6
21.9
19.3
22.9
18.2
19.6
2008
29.0
21.9
19.4
23.0
17.0
18.1
2009
27.3
19.0
16.5
19.7
14.2
14.7
2010
26.8
19.2
17.3
19.8
15.4
15.8
2011
27.2
20.1
18.0
19.9
14.8
15.9
1980s
26.8
20.9
24.5
29.6
18.5
20.5
1990s
24.6
18.9
22.6
28.8
17.4
18.7
2000s
26.7
19.9
18.5
22.3
16.7
18.5
1980s
7.3
6.4
6.0
5.9
10.5
4.9
1990s
5.7
10.2
6.1
8.5
7.0
6.5
2000s
6.3
5.8
8.6
7.7
7.3
10.9
Average
CV
Source: IMF World Economic Outlook Database, April 2012.
Note: The total investment ratio is expressed as a ratio of total investment in current local currency and GDP in
current local currency. Investment or gross capital formation is measured by the total value of the gross fixed
capital formation and changes in inventories and acquisitions less disposals of valuables for a unit or sector.
Gross and Net Investment
Gross Investment is defined as the total addition to the existing capital stock. However, in any given period,
some of the existing capital will become inoperative due to wear and tear and have to be replaced. This
component of spending is termed depreciation.
Net Investment subtracts depreciation from Gross Investment. Depreciation is the reduction in the capital stock
that occurs each period through wear and tear.
Thus net investment is the increase in the capital stock per period. In any given period, net investment could be
negative. If firms decide they have too much capital given their expected sales then they will invest less than is
necessary to maintain the size of the existing capital stock. Thus the depreciation will be larger than the gross
investment which means net investment would be negative.
What determines the decision by firms to invest?
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The most elementary explanation is based on the observation that business firms require stocks of capital on
hand to produce output. In this context, they have to consider two broad aspects of the production decision:
1.
Will the size and composition of the capital stock in place allow them to produce at the lowest
cost?
2.
Is the capital stock adequate to produce the expected output in the coming periods?
The analysis that business firms engage in to answer these questions then determines their investment decision.
Investment attempts to bridge the gap between the current capital stock and the desired capital stock based on
their analysis of future expected output. Investment will be high when the current capital stock is low relative to
expected needs. Conversely, investment will be low when the current capital stock is high relative to expected
needs.
Given that capital goods last for many years, the capital stock will typically be large relative to current national
income (GDP) and current investment (I). Table 12.2 compares the estimated capital stock and GDP for various
countries in 2010. The average capital stock for the OECD nations shown for 2010 was 2.4.
Table 12.2
Capital stock and GDP, various countries, 2010, in local currencies
Country
Capital Stock
Real GDP 2010
Capital – Output Ratio
Australia
2855502562904.5
1298899000000.0
2.2
Austria
683016438587.7
263318242440.0
2.6
Belgium
807852718331.3
348087000000.0
2.3
Canada
3226833382833.6
1325037816083.2
2.4
Denmark
4568552398093.7
1547770000000.0
3.0
Finland
362653166133.4
159013000000.0
2.3
France
4230468965067.0
1774518000000.0
2.4
Germany
5737703431790.1
2364092420000.0
2.4
Greece
448075712790.1
195587624964.0
2.3
Hungary
35266718116574.6
21807370000000.0
1.6
Ireland
253296673200.7
159914943107.0
1.6
Italy
3964191046721.6
1422432146849.0
2.8
Japan
2050900350854080.0
540409600000000.0
3.8
Netherlands
1305843961586.5
550919934367.8
2.4
New Zealand
352514299624.1
140600000000.0
2.5
Portugal
275424755465.1
162192800000.0
1.7
Spain
3387205933615.5
1046329000000.0
3.2
Sweden
6427754866460.2
3300858000000.0
1.9
Switzerland
1440785679206.7
497771589898.1
2.9
United Kingdom
2322823133929.6
1395312000000.0
1.7
United States
27187279574163.3
13087975000000.0
2.1
Source: OECD Economic Outlook, Volume 2011, Issue 2 – No. 90
[NOTE - THIS TABLE IS TO BE REVISED]
If business firms maintain these typical ratios then small changes in GDP will lead to large changes in the
amount of capital goods required. So when the change in GDP (ΔY) triggers the desire to change the capital
stock, large fluctuations in investment usually occur.
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This observation is the basis of the Accelerator model of investment.
Advanced Material
We can express the simple accelerator model in terms of the following two equations:
(12.1)
DESIRED CAPITAL STOCK: K* = vY
(12.2)
INVESTMENT MODEL: It = [K*t - K*t-1] + IR
The subscript t refers to some specific time period so t is the current time period and t-1 is the last period (which
could be last month, quarter, year or whatever depending on the frequency of the data).
IR is the replacement investment (depreciation). So Equation (12.2) says that the current flow of investment
spending (It) is equal to the change in the capital stock plus depreciation.
Combining the two equations by substituting K* into Equation (12.2) we get the Simple Accelerator Model:
(12.3)
It = [vYt - K*t-1] + IR
This tells us that the flow of investment demand (spending) will be equal to replacement investment
(depreciation) plus the desired capital to output ratio (v) multiplied by the change in GDP. Remember v is the
accelerator coefficient.
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12.2
The Accelerator Model of Investment
The Accelerator model of investment is based on the observation that increases in GDP lead to increases in the
desired stock of capital (denoted K*).
The desired stock of capital (K*) is the amount of capital that business firms would like to have in place given
the current and expected economic conditions. As a result of the capital stock (K) being carried over from the
previous period and increase in GDP which leads to an increase in K* will lead to a discrepancy or gap between
the actual capital stock in place and K*.
Investment behaviour is characterised as the attempt by the business firms to close this gap. The accelerator
terminology is based on the fact that small changes in GDP will drive larger or accelerated changes in
investment demand (spending).
The Simple Accelerator Model
With a given production technology (that is, state of art) we consider the capital to output ratio (K/Y) to be
fixed. This means that it takes a fixed collection of capital (K) to produce a given output level (Y).
We use this simple assumption to define the desired capital stock (K*) as:
(12.4)
K* = vY
Where the fixed multiple v, is the desired capital to output ratio (K/Y). This means that to produce Y firms have
to have K/v in place.
For example, if the capital to output ratio was 2 and output was expected to increase by $10 billion then firms
would revise their desired capital stock upwards by $20 billion to ensure they had enough productive capacity in
place to meet the expected increase in demand for goods and services.
In order to increase the capital stock to meet the change in desired capital stock, firms will invest. While this
model of investment is too simple and we will complicate it further later in the Chapter, it does provide some
essential and useful insights that describe investment behaviour in most economies.
These insights are:

Investment demand will be much more variable than GDP because investment is a multiple of
the change in income (GDP).

In an actual economy, investment starts to decline before an economy goes into recession. In
other words, we can use turning points in the flow of investment spending to make predictions
about the direction of the business cycle. It is clear that when GDP is rising in the early stages
of a recovery, then the change in income will be positive and investment will be high. But as
the growth in GDP tapers off, the change in income decreases which means that investment
starts to decline even though the level of GDP may still be rising.
A practical example will help you understand how this model works. Assume that the accelerator coefficient (v)
is equal to 3 and replacement investment is a constant $400 per period. Assume the economy has an initial
capital stock of $12,000.
Table 12.3 shows the Simple Accelerator Model of investment spending in action for 8 hypothetical periods
where income initially grows from $4,000 to a peak of $4140 then declines back to $4000.
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Table12.3
Period
(t)
The Simple Accelerator Model
Expected
GDP
Level
$
(1)
(2)
Expect
ed
Chang
e in
GDP
$
Net
Investmen
t
(vΔY)
IR
Gross
Investment
K*0
K*(=vY)
GAP
(5)
(6) = (4)+(5)
(7)
(8)
(9)=(8)-(7)
(4)
(3)
1
4000
0
0
400
400
12000
12000
0
2
4040
40
120
400
520
12000
12120
120
3
4120
80
240
400
640
12120
12360
240
4
4140
20
60
400
460
12360
12420
60
5
4120
-20
-60
400
340
12420
12360
-60
6
4080
-40
-120
400
280
12360
12240
-120
7
4000
-80
-240
400
160
12240
12000
-240
8
4000
0
0
400
400
12000
12000
0
You might like to create a spreadsheet yourselves to replicate the table and then start varying the key inputs
(expected aggregate demand, the capital-output ratio) to see what happens to investment.
Table 12.4 shows the time path of investment spending described in Table 12.3. You can observe that
fluctuations in GDP growth drive much larger fluctuations in investment spending growth.
Table 12.4
Time path of investment in Simple Accelerator Model
Period
Growth in GDP (%)
Growth in Gross Investment (%)
2
1.0
30.0
3
2.0
23.1
4
0.5
-28.1
5
-0.5
-26.1
6
-1.0
-17.6
7
-2.0
-42.9
1
Figure 12.1 captures the relationship between the change in GDP and Gross Investment. The increased
variability of investment for a given change in GDP is very stark.
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Figure 12.1
Relationship between change in GDP and Gross Investment, Simple Accelerator Model
1200
1000
$ per period
800
600
400
200
0
-200
-400
1
2
3
4
Gross investment
5
6
7
8
Change in GDP
Limitations of the Simple Accelerator Model
While the Simple Accelerator Model is a useful guide it is too simplistic for the following reasons:

The desired capital stock K* is unlikely to remain a fixed proportion of GDP. That is, the
accelerator coefficient v is likely to be variable in the real world.

Following a change in GDP, business firms do not attempt to close the gap between their
actual and desired capital stocks immediately. That is, like most adjustment process in the real
world, adjustment takes place gradually over time.
These observations led economists to develop the Flexible Accelerator Model, which adds some complexity to
the explanation of investment.
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12.3
The Flexible Accelerator Model
This model of investment behaviour assumes that for a time, business firms can continue to function adequately
with a capital stock that is not exactly equal to its desired capital stock.
There are several reasons why firms might want to adjust gradually to their desired capital stock:

Adjusting the capital stock is very costly especially as suppliers usually charge premiums for
faster delivery.

There are intrinsic time lags involved. It takes time to undertake project evaluation to consider
the type of capital, the likely suppliers, the financing arrangements, the delivery details and
the installation and training associated with the new equipment.
For these reasons, while investment is motivated to closing the gap between the actual capital stock and the
desired capital stock (K* – K), there is incomplete adjustment in the short-run.
Business firms employ alternative strategies to maintain operations and production with a less than desired
capital stock. These include running extra shifts – that is, spreading more labour resources over the existing
capital stock; providing opportunities for over-time and extended working weeks.
The Flexible Accelerator Model thus conceives that business firms adjust to increased output by employing a
combination of more labour and some investment which augments the capital stock. Over time, they catch up
with their desired K*, although in a growing economy, they are always likely to fall short, given the incomplete
adjustment process conceived here.
Rate of Adjustment in the Flexible Accelerator Model
The additional question that then arises is what is the speed of adjustment (which we might denote as d)?
The rate of adjustment (d) is the fraction or proportion of the gap (K* – K) that is closed by the flow of
investment per period. If the gap is mostly closed (that is, firms get close to their desired capital stock quickly)
then d will be large and we consider the rate of adjustment to be fact. If the speed of adjustment is slow, the gap
persists over a long period.
What does the rate of adjustment depend upon? There are several determinants that economists have identified:

Adjustment costs – the costs of financing (for example, determined by the interest rate).

Time factors – how long does it take for new capital equipment to be evaluated, designed,
ordered, produced, delivered and installed.

Economic conditions – interest rates, expected returns on production, animal spirits (business
sentiment).
We might say that the higher the interest rates the higher the costs of financing capital equipment purchases
(other things being equal) and so the slower the adjustment will be.
Further, bouts of pessimism will slow down adjustment. We will return to this issue later in the Chapter when
we consider the asymmetric nature of investment demand.
We will return to the impact of higher interest rates presently.
Implications of Incomplete Adjustment
By comparison with the Simple Accelerator Model, if in each period the adjustment to the desired capital stock
is less than 100 per cent then the gap between K* and K will remain non-zero. That is, the actual capital stock
will not equal the desired capital stock.
In the Flexible Accelerator Model, the flow of investment demand (spending) is dependent not only on the gap
between K* and K but also the speed of adjustment.
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Advanced Material
The following equation captures this formally:
(12.5)
It = d[vYt - K*t-1] + IR
So with K* = vYt then the extent to which the gap between desired and actual is closed determines the
investment flow in addition to the replacement investment (depreciation).
What affect does this have on investment spending?
The partial adjustment smooths out the impact of a change in GDP on the flow of investment demand over
several periods. Thus sustains investment even when output growth falls.
The Simple Accelerator Model posited what we might term an explosion-contraction pattern of investment
demand which is clearly unrealistic. The Flexible Accelerator Model predicts a smoother investment path but
still highly variable.
Consider the case of a growing economy. Investment spending will be positive because the actual capital stock
is below the desired capital stock (K*). Business firms use investment to adjust towards their desired capital
stock. So investment demand depends on two factors:

The amount needed to replace the capital that has been worn out (depreciation), I R.

The positive or negative amount necessary to adjust for the change in GDP.
[NOTE = A TABLE AND GRAPH COMPARING THE SAM AND THE FAM TO COME HERE]
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12.4
Expectations and Interest Rate Impacts on Investment Demand.
We saw in the discussion of the Flexible Accelerator Model of investment demand that economic conditions
have an impact on the estimates of desired capital stock by business firms.
Two factors were identified as being important:

Expectations of future economic conditions.

The interest rate.
Business firms are continually forming expectations about future output. Firms have to make resource
commitments (working capital, labour etc) well in advance of realisation (sales) and so the scale of production
at any point in time reflects the guesses they make in a highly uncertain world.
The extent to which investment demand follows the Flexible Accelerator model of capital stock adjustment
depends on these expectations.
Managers wonder whether a change in output that they observe in the current period will be sustained or not.
They consider whether observed changes in output are the result of transitory (ephemeral) factors or are likely to
be enduring. They wonder whether a rise in demand (output) today might not be followed by a fall tomorrow.
The Flexible Accelerator Model of investment is called a partial adjustment model (PAM) and the lack of
complete adjustment to the desired capital stock reflects, in part, the uncertainty about the duration of the change
in income.
When output is unusually high, business firms might form the view that it will taper off and so they will allow
the current capital stock to depreciate more than usual (that is, net investment will be negative).
Alternatively, when they consider output levels to be unusually low, a reasonable expectation is that it will rise
and so firms overinvest in the short-run to ensure they have enough capital in place to meet their expected future
demand. In other words, they create productive capacity that is beyond their immediate requirements.
What about the interest rate?
[NOTE DISCUSSION HERE ABOUT KEYNES and MARGINAL EFFICIENCY OF CAPITAL ETC]
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12.5
Cyclical Asymmetries in Investment Spending
Another aspect of investment behaviour that we observe in the real world is asymmetry. Investment in new
capital stock usually requires firms to make large irreversible capital outlays.
Capital is not a piece of putty that can be remoulded in whatever configuration that might be appropriate (that is,
different types of machines and equipment). Once the firm has made a large-scale investment in a new
technology they will be stuck with it for some period.
In an environment of endemic uncertainty, firms become cautious in times of pessimism and employ broad
safety margins when deciding how much investment they will spend.
Accordingly, they form expectations of future profitability by considering the current capacity utilisation rate
against their normal usage.
They will only invest when capacity utilisation, exceeds its normal level. So investment varies with capacity
utilisation within bounds and therefore productive capacity grows at rate which is bounded from below and
above.
The asymmetric investment behaviour thus generates asymmetries in capacity growth because productive
capacity only grows when there is a shortage of capacity.
This insight has major implications for the way in which economies recover and the necessity for strong fiscal
support when a deep recession is encountered. We will consider these issues in Chapter 13 Government and
Fiscal Policy.
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12.6
Investment and Profits
What is the relationship between investment spending and the profits that a firm receives? The origin of profits
has been an on-going debate among economists since Capitalism succeeded Feudal modes of production.
[NOTE DISCUSSION OF MARX AND SURPLUS VALUE AS THE ORIGIN OF PROFITS]
In this section we consider the theory of profits that was developed by Polish economist, Michal Kalecki, who
was one of the early pioneers in developing an understanding of the origins of profits from a macroeconomic
perspective.
There were two versions of Kalecki’s theory – a simplified version which outlined the fundamental profits
equation and the more realistic expanded version which outlined the generalised profits equation.
Tables 12.5 and 12.6 show the tables that were originally published in Kalecki’s 1952 book – Theory of
Economic Dynamics – which was republished in 1965 by Allen and Unwin, London.
The tables show the simplified and generalised versions of the Kalecki’s profits equations.
Table 12.5
Kalecki’s Simplified Profits Model
Income
Spending
+ Gross Profits
+ Gross Investment
+ Wages and Salaries
+ Capitalist’s Consumption
+ Workers’ Consumption
= Gross National Product
Table 12.6
= Gross National Product
Kalecki’s Generalised Profits Model
Income
Spending
Gross Profits net of taxes =
+ Gross Investment
+ Export Surplus
+ Budget Deficit
- Workers’ Saving
+ Capitalist’s Consumption
Kalecki was trained under a Marxist system and so had an advanced understanding of how the production of
surplus value pre-dated but determined profit realisation. The mainstream idea that profits were generated in the
“exchange” process (where goods and services are bought and sold) and reflected the marginal contribution of
capital was dismissed.
[NOTE - brief section here differentiating Kalecki's effective demand emphasis from Marx's surplus
value focus]
What Marx didn’t show in his approach to profits was how the total volume of profits in a monetary economy
was determined in any given period. That was the question that Kalecki sought to answer.
When students first confront the question of the determination of profits from a macroeconomic view they have
trouble reconciling it with the more normal approach to accounting at the firm level.
As we have learned in earlier chapters, it is easy to fall into the trap of the fallacy of composition where we
apply what we observe at the individual level to the macroeconomic level. In this case, attempting to formulate a
macroeconomic theory of profits by applying the logic that an individual firm might apply to calculate their
profits will lead us astray.
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Think about this example. Wage costs are a significant proportion of total costs at the firm level. So if an
individual firm was to achieve significant reductions in its wage costs, then it might expect to enjoy increased
profits.
Imagine if all firms simultaneously attempted the same strategy. What would you expect to happen?
Given wage costs are also worker incomes and as we have learned, spending is driven by income, we would
expect the total revenue for firms to decline as they cut wage costs. There is no reason to expect that overall
profits would rise in the economy.
Further, investment may also decline as total spending declines, which would further damage the revenue side
of the business sector.
The first task then is to determine what factors are important for creating the overall level of profits in the
economy.
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12.7
Kalecki’s Simplified Model
In his simplified model, Kalecki assumed that the economy was comprised of two groups:

Workers who earned wages and did not save; and

Capitalists who produced and earned profits.
He also assumed that the economy was closed and that there was no government sector.
Under these highly simplistic assumptions, Kalecki concluded that “workers spend what they get” and
“capitalists get what they spend” which means that capitalist profits are determined by their own propensity to
invest and consume which reverses the way people normally consider the causation.
That is, profits are determined by investment not the other way around.
While Kalecki clearly knew that workers also save, he was able to show that by adopting the restrictive
“workers do not save” assumption the basic insights were not altered but rendered more easy to understand.
To reach that conclusion, Kalecki began with the familiar National Accounting identity, which we developed in
full in Chapter 8. In his simplified model, the basic aggregate demand equation is written as:
(12.6)
GNP = C + I
Where GNP is Gross National Product or total output and national income, C is total private (household)
consumption, and I is total private investment spending per period. These aggregates are all flows of
expenditure (and hence income).
Note he used GNP rather than Gross Domestic Product (GDP) because he assumed the economy was closed.
Refer back to Chapter 5 National Income and Product Accounts if you need to refresh your memories of the
difference between these two aggregates.
Private investment is the sum of spending (output) of new productive capital plus changes in inventories.
In terms of analysing how the total income produced was distributed, Kalecki assumed that there were two
“classes” – workers and capitalists – which shared the national income such that total wages and salaries (V)
plus total profits (P) equals GNP.
Kalecki expressed the distribution of national income in this way:
(12.7)
GNP = V + P
P is gross profits, which includes depreciation, retained profits, dividends, drawings from unincorporated firms,
rent and interest.
Equation (12.6) describes the national product from the spending (demand) side, while Equation (12.7)
considers the same aggregate from the perspective of how it is distributed.
If we set the two different views of the National Accounts equal we get:
(12.8)
V+P=C+I
Or:
(12.9)
P=C+I–V
Note that (C – V) is that component of consumption that is attributed to the capitalists (given workers’
consumption is equal to V – that is, they “spend what they get”).
Equation (12.9) can be read as saying that gross profits (P) is equal to capitalists’ consumption (C-V) plus gross
investment. That is, the capitalists “get what they spend”.
This is the model presented in Table 12.5.
Clearly, the simplified (fundamental) profits equation was derived from the national accounts and so is true by
definition. Kalecki sought to expand his analysis further by explaining the causal dynamics that led to the
existence of profits overall (at the macroeconomic level) – which linked the two sides of the fundamental
equation.
The question of interest is which way the causality flows – from left to right – Do profits determine capitalist
consumption and investment? – which is the intuitive way of thinking – or from right to left – Do capitalist
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consumption and investment determine profits? Kalecki clearly considered the latter causality to be the valid
way of understanding profits.
He said (in his 1965 book Theory of Economic Dynamics, pages 45-46):
The answer to this question depends on which of these items is directly subject to the decisions of
capitalists. Now, it is clear that capitalists may decide to consume and to invest more in a given
period than in the preceding one, but they cannot decide to earn more. It is, therefore, their
investment and consumption decisions which determine profits, and not vice versa.
He recognised that there was a time-lag involved between spending and profits. It is the recognition of this time
lag that allowed Kalecki to derive his business cycle model, which we consider later in this Chapter.
The essential insight is that investment spending depends on expectations of future aggregate demand that are
formed in some prior period.
These spending decisions then drive economic activity and so profits are a function of investment in some prior
period and these flows can be variable.
In effect, he foresaw an accelerator type process operating. Later in the Chapter we will consider how the
accelerator interacts with the expenditure multiplier, which we derived in Chapter 8, as part of a broader
explanation of business cycles.
It is clear that in the simplified profits model – capitalist’s gross saving equals gross investment. Kalecki (like
Keynes) demonstrated that the equality of saving and investment was totally independent of the level of interest
rates which were determined in the money market. But remember the simplified model assumes only two
sectors – households and firms.
The neoclassical approach considered interest rates adjusted to equilibrate (real) saving and investment and thus
ensure that aggregate demand would always be equal to aggregate supply – thus negating the possibility that the
economy could suffer from a shortage of demand. This denial of unemployment was the basis of Say’s Law
(later Walras’ Law).
However, Keynes and Kalecki clearly understood that saving and investment were brought into equilibrium (in
a closed economy without a government sector) by variations in national income driven by changes in effective
(aggregate) demand. That insight provided the fundamental break with neoclassical thinking that dominated
economics (and policy) at the onset of the Great Depression and which, when applied, worsened the depression.
So in Kalecki’s model, fluctuations in spending drive fluctuations in output and income which ensure the
demand drain (saving) comes into equality with spending injections (investment).
This is also the basic idea that drives the spending multiplier model. Thus increased investment spending
stimulates aggregate demand and firms respond by increasing production.
This, in turn, leads to higher wage and salary payments and higher induced consumption which feeds back into
the spending stream and promotes further output and income. At each stage of the process, some of the income
generated goes to saving and so the successive consumption spending flows become smaller and smaller until
they exhaust. At that point, the sum of the saving generated by the income responses will equal the initial
investment injection and the economy regains equilibrium.
A person thinking from a micro perspective might think the profits equation is odd – after all, if the capitalist
consumes more the volume of funds they have at the end of some period should be less. It is here that the fallacy
of composition enters the fray.
Kalecki asked “what would be the sources of financing this investment if capitalists do not simultaneously
reduce their consumption and release some spending power for investment activity?” He responded as such (in
his 1966 book – Studies in the Theory of the Business Cycle (Blackwell, Oxford), page 46):
It may sound paradoxical, but according to the above, investment is ‘financed by itself’.
While that might be true for an individual business firm, acting in isolation, it cannot be true for the economy as
a whole. This is because the consumption of one capitalist becomes the source of profits for another capitalist.
This insight allows us to understand the statement that capitalist investment brings forth its own saving!
Kalecki clearly understood the counter-intuitive notion that investment “automatically furnishes the savings
required to finance it” as long as there is idle capacity. That is, as long as increasing aggregate demand does not
outstrip the real capacity of the economy to produce.
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12.8
Kalecki’s Generalised Model of Profits
Introducing economic dynamics Posted on Friday, August 3, 2012 by bill
Kalecki subsequently complicated his simplified two-sector model to include a foreign sector, a government
sector and a recognition that workers do save. He considered this generalised theory to be applicable to the real
world.
He sought to sought to examine the influence of the budget deficit, the external sector and workers’ savings on
total profits.
In Chapter 8 we introduced the real expenditure model of national income determination and derived the
aggregate demand equation as:
(12.9)
Y = C + I + G + NX
where Y is national income (aggregate spending), G is government spending and NX is net exports (total
exports minus total imports). In Kalecki’s model where workers and profit recipients were distinguished, C is
taken now to be the aggregate of capitalists’ consumption (Cp) and workers’ consumption. Workers’
consumption is equal to total worker income post tax (Vn) minus workers’ saving (Sw).
To recognise the different sources of total consumption, Equation (12.9) could thus be written as:
(12.10)
Y = Cp + (Vn – Sw) + I + G + NX
Total income claimants on national income (Y) are:
(12.11)
Y = P n + Vn + T
where P and V are as before (profits and total wages and salaries) but the subscript n denotes these flows are net
of taxes paid, and T is total taxes.
Thus (setting the expenditure components of total income equal to the claims on total income) we get:
(12.12)
Cp + (Vn – Sw) + I + G + NX = Pn + Vn + T
We can solve this for Gross Profits after tax (Pn) to get:
(12.13)
Pn = I + (G – T) + NX + Cp + Vn – Sw – Vn
So:
(12.14)
Pn = I + (G – T) + NX + Cp – Sw
which says that gross profits after tax (Pn) equals gross investment (I), plus the budget deficit (G – T), plus the
export surplus (NX), plus capitalists’ consumption (Cp) minus workers’ saving (Sw).
This is the model shown in Table 12.6.
Gross profits after tax will be higher, the higher is gross investment (I), the larger the budget deficit (G – T), the
higher is capitalists’ consumption (Cp) and the lower is workers’ saving (Sw).
[NOTE: A SECTION ON THE BEHAVIOURAL FACTORS THAT INFLUENCE Cp and Sw TO BE INSERTED
HERE]
Kalecki identified some interesting features of this model.
For example, when there are positive net exports and/or budget deficits, then gross net profits (Pn) will rise
higher than the level that would be generated by gross investment and capitalist consumption (as in the
simplified model).
So an individual domestic capitalist who is able to increase their net exports will be able to glean extra profits
“at the expense of their foreign rivals” [NOTE: GET EXACT QUOTE FROM Kalecki, 1964:51).
Kalecki said (in his 1965 book noted above, page 51):
It is from this point of view that the fight for foreign markets may be viewed.
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[NOTE - A FURTHER ELABORATION OF THE FOREIGN SECTOR WILL APPEAR IN CHAPTER 15 THE OPEN
ECONOMY]
Anticipating the discussion of fiscal policy in Chapter 13, Kalecki’s generalised model of the determination of
aggregate profits considered budget deficits added to capitalist profits through their positive effect on national
income. The budget deficit leads to the private sector receiving more dollar flows from government spending
than it is returning to the government via taxes. Budget deficits thus provide an increased capacity for capitalists
to realise their production plans and sell output because they expand the total aggregate demand in the economy.
Kalecki said that budget deficits allow the capitalists to make profits (net exports constant) over and above what
their own spending will generate.
Government spending not only directly stimulates aggregate demand, but through the multiplier effect it also
increases the incomes of household, who, in turn, purchase goods and services from firms.
The opposite is the case if the government runs a budget surplus – where spending is less than taxation revenue
– then aggregate profits are reduced. There are two ways in which this occurs. Aggregate spending falls which
reduces the revenue that firms receive. Further, if the surplus is achieved with increased business tax rates, then
the firms have less after tax profit.
The only time that a rising budget deficit will not add to real profits is if there is full capacity and the rising
deficits push nominal aggregate demand beyond the real capacity of the economy to increase output and real
income.
A recurrent theme in the public debate which we will consider in Chapter 18 Policy Debates is the issue of
crowding out. We also consider the concept of crowding out in Chapter 13 Fiscal Policy.
Basically, many economists think that government spending and private investment compete for a finite pool of
saving and this competition has to be resolved by higher interest rates, which damages private investment.
Accordingly, budget deficits are said to “crowd out” private spending. The same economists typically add a
further argument to justify their claim that budget deficits are damaging. They allege that public spending is
generally wasteful in comparison to private spending because the latter is allegedly “disciplined” by the market.
This is in reference to their belief that the self-regulating market results in the most efficient allocation of
resources because inefficient uses of resources are priced out of use by demand and supply forces.
As a preliminary insight into why the crowding out argument is without substance, we can reflect on Kalecki’s
profit determination model.
The crowding out argument relies on the claim that savings are finite and borrowers have to compete with each
other to gain access to that finite pool.
Consider the conclusion that rising private saving (lower propensity to consume) and/or falling deficits impact
negatively on profits. The impact is via declines in national income overall. It is probable that when firms are
experiencing a reduction in profits as the conditions in the goods and services market deteriorate, that they will
reduce their rate of investment.
Equally, private investment adds to private profits and brings forth its own saving via the expansion of national
income. In the same way, budget deficits add to private profits and, if accompanied by debt issuance, merely
borrow back the funds they spend and stimulate growth in saving via the expansion of national income.
These are fundamental insights of a modern monetary economy that were well understood by Kalecki in his
work on the determination of profits and the dynamics of a capitalist economy.
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12.9
Business Cycles – Fluctuations in Economic Activity
In the last section, we considered Michel Kalecki’s theory of aggregate profit determination. We gained an
understanding of the way in which profits vary as national income fluctuates in response to variations in
capitalist consumption and investment, workers’ saving, the budget balance and the external balance.
The fluctuations in economic activity and the resulting changes in national income are refered to as the business
cycle. When economists refer to the business cycle they are considering fluctuations in economic activity that
arise from variations in overall spending.
As a matter of terminology, economists often reference an economic variable in terms of the business cycle.
There are three broad relationships:

Counter-cyclical – which occur when a variable rises (falls) when the level of economic
activity falls (rises). That is, we would observe a negative correlation between the variable and
economic activity.

Pro-cyclical – which occur when a variable rises (falls) when the level of economic activity
rises (falls). That is, we would observe a positive correlation between the variable and
economic activity.

Acyclical – there is no relationship between the variable and economic activity. That is, there
would be a zero correlation between the two variables.
Typical pro-cyclical variables are household consumption, business investment, imports and employment.
Typical counter-cyclical variables are unemployment and underemployment, and the budget balance (we will
explain this in more detail in Chapter 13 when we consider fiscal policy).
Economists also consider macroeconomic variables in terms of the timing of the business cycle. The points in
time when the cycle moves expansion to contraction (the peak) or contraction to expansion (the trough) are
referred to as turning points.
A variable that demonstrates cyclical behaviour before real GDP has “turned” is referred to as a leading
indicator because its movement pre-dates the change in direction of the cycle.
Well-known leading indicators include new housing starts; new spending (orders) on plant and equipment by
firms; purchase of consumer durables by households; and new job creation by firms.
Conversely, a variable that demonstrates cyclical behaviour after real GDP has “turned” is referred to as a
lagging indicator because its movement post-dates the change in direction of the cycle.
Well-known lagging indicators include the rate of inflation; the change in persons employed; and the rate of
wage inflation.
[NOTE A TABLE HERE SHOWING THE KEY MACROECONOMIC VARIABLES IN TERMS OF THEIR
LAG/LEAD STATUS AND THEIR CYCLICALITY]
Figure 12.2 depicts a stylised business cycle detailing the essential elements that economists identify. These
elements include the recovery or growth phase where real GDP is increasing period after period until it reaches
the peak – the point at which real GDP reaches its localised maximum.
The economy then goes into a downturn of some severity – sometimes moderate and other times severe – where
the real GDP declines overall. If this phase lasts for two or more successive quarters then the economy is said to
be in recession. At some point the economy reaches the trough, which is the lowest point real GDP reaches of
that particular cycle.
The trend real GDP growth rate depicts the underlying direction of real GDP by ignoring the cyclical
fluctuations.
Note also that the real GDP growth can accelerate or decelerate while still remaining positive. For a recession to
occur, the level of real GDP has to decline (that is, negative growth must occur).
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Figure 12.2
A Stylised Business Cycle
Real
GDP
Peak
Trend GDP
Recession
Recovery
Trough
Time
Figure 12.3shows the evolution of annual percentage growth in real GDP for Australia from 1960 to the firstquarter 2012. The data is derived from the Australian National Accounts available from the Australian Bureau
of Statistics and is quarterly in frequency. The formula used to calculate the annualised growth rate from
quarterly data is as follows:
(12.15) Annual Growth = 100*(Real GDPt – Real GDPt-4)/Real GDPt-4
where the t subscript refers to the quarter in question. So if t was March 2012, then t-4 would be March 2011
and so on.
The graph depicts several business cycles over this period of different intensities. While each nation experiences
different intensities of growth and contraction between peaks, the Australian experience is representative of the
general pattern of economic development.
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Figure 12.3
Australian real GDP growth, 1960-2012, per cent per annum
Source: Australian Bureau of Statistics, National Accounts data.
Economic fluctuations are not regular occurrences by which we mean the time span between peaks and troughs
and the depth (amplitude) of the cycle are variable over time. While Figure 12.7 depicted peaks that increased
over time it is possible to envisage a peak that falls below the previous peak.
The point to understand is that economic activity moves over time in these wave like patterns oscillating
between peaks and troughs as aggregate demand fluctuates.
We refer to a single business cycle as the time between two peaks because that period contains a completed
upswing and downswing.
Other terminology has been used in relation to the business cycle. For example, economists sometimes
differentiate between an recovery (upswing) and a boom in terms of the relationship to real GDP to its trend. So
a recovery (from a trough) becomes a boom, once real GDP exceeds its current trend value.
Further, a downturn might describe the fall in real GDP between the peak and the trend line, whereas the
economy might be considered to be in recession once real GDP moves below its current trend level.
A very deep and drawn out recession is sometimes referred to as a depression and, fortunately, governments
have a good understanding of the policy tools at their disposable (fiscal and monetary policy) to ensure we
rarely encounter recessions so harsh that we consider them to be depressions.
The Interaction of the Expenditure Multiplier and the Investment Accelerator
In Chapter 8, we introduced the concept of the expenditure multiplier which demonstrated how an injection of
spending into the economy would, if there was excess capacity, multiply as the extra income generated was respent.
In this Chapter, we introduced the accelerator model of investment spending, whereby a firm would augment its
capital stock through investment spending in order to have enough capital available to produce the expected
demand for its output.
In this section we bring the two concepts together to show how a business cycle might evolve.
The material that follows is considered advanced and is based on the work by Roy Harrod [NOTE
REFERENCE HERE]. The essential idea can be described in a relatively straightforward way.
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The accelerator theory of investment spending is based on the notion that net investment is driven by expected
changes in output demand. Firms thus seek to put in place capital stock which will be sufficient to produce the
expected demand for their output at current technology and practice.
The multiplier concept indicates that when there is an exogenous boost in aggregate spending (for example,
from government, investment and/or exports) the initial spending increase is multiplied through the expenditure
system as consumers are induced by the rising income to increase their consumption.
The two concepts can thus interact. A multiplied spending increase and growth in output will, in turn, increase
investment via the accelerator principle.
Given investment is a component of aggregate spending, the rise in net investment will, in turn, have a
multiplied impact on total spending and output and so the economy moves into an upward phase in the business
cycle.
But once the economy reaches a peak in real GDP, the accelerator becomes a negative influence on net
investment which then via the multiplier generates a decline in total spending.
So there is an interaction between investment as an exogenous driver of the multiplier and investment as an
induced spending reaction as a result of the accelerator principle.
This was the basic insight that underpinned the Harrod-Domar model of economic cycles (and growth) and
supports the notion developed by Keynes that we considered in Chapters 10 and 11 on the labour market, that
the economy has no natural full employment level that it gravitates towards.
In those chapters, we learned that is because the capitalist economy is prone to under-full employment
equilibrium positions which have to be disturbed by government policy stimulus.
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Advanced Material
The Flexible Accelerator was defined as:
(12.15)
It = d[vYt - K*t-1] + IR
If we only consider net investment we can ignore replacement investment (I R) because it is likely to change
slowly and not be a significant determinant of the business cycle.
We also ignored inventory investment to keep the model simple. More elaborate accelerator models would
consider firms adjust their inventories to ensure they can meet unexpected demand changes subject to carrying
costs.
To add an element of reality to the model we would hypothesise that when making their net investment
decisions, firms respond to changes in output last period rather than the current period. Further, in the real
world, households adjust their consumption with a lag and so in the following model we use last period’s
disposable income as the decision-making variable for households.
Combining the acceleration theory of investment with these assumptions, we can write the aggregate
expenditure model as:
(12.16)
Yt = cYt-1 + It = d[vYt-1 - K*t-1] + G + NX
where cYt-1 is household consumption and It = d[vYt - K*t-1] is net private investment. For simplicity we assume
that the tax rate is zero so we can ignore it and that the propensity to import is zero so NX is just exports. These
assumptions allow us to simplify the calculation of the multiplier.
We defined K* earlier in the Chapter as being equal to vYt-1. It follows then that K*t-1= vYt-2.
Accordingly, Equation (12.16) can be re-written as:
(12.17)
Yt = cYt-1 + It = dv[Yt-1 - Yt-2] + G + NX
If we had equilibrium, then real GDP is constant which means that Yt = Yt-1 = Yt-2 = Y*. So we can solve
Equation (12.17) for its equilibrium or steady-state properties as:
(12.18)
Y* = cY* + G + NX
Note that the Accelerator term drops out when real GDP is constant.
We re-arrange Equation (12.18) as follows (calling G + NX = A)
(12.19)
Y* = 1/(1-c)A
Equation (12.19) says that total real income will be a multiple [1/(1-c)] of autonomous spending A. We could
have expressed this in terms of the full expenditure multiplier that we derived in Chapter 8, but we lose no
explanatory power here by using a simplified expression.
As an example, assume the marginal propensity to consume was 0.8 and A was 100. From Equation (12.19) we
would solve the equilibrium level of real income to be Y* = 5 x 100 = 500.
If, for example, the government increased its autonomous spending and A rose to 120, then the new higher
equilibrium national income would be 600.
The understanding you gain from these results is that:

The equilibrium level of real output and income is not determined by the impact of the
accelerator; and

The total change in the equilibrium level of real output and income is determined by the
change in autonomous spending and the expenditure multiplier, which is the result we derived
in Chapter 8.
So what role does the investment accelerator play? The answer is that once we consider the dynamics of the
macroeconomy – the way in which it moves over time – the interaction between the expenditure multiplier and
the accelerator becomes relevant.
The previous example merely considered two snapshots where the economy was (temporarily) at rest. How it
traversed between those two steady-states is the domain of economic dynamics and business cycle analysis.
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[NOTE - A TABLE IS COMING HERE TO SHOW THE DYNAMICS OF THE SYSTEM]
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Investment and interest rates Posted on Friday, August 10, 2012 by bill
12.10 Introduction to Cash Flow Discounting and Present Value
Investment and production decisions taken by firms are influenced by the expectations that entrepreneurs form
about future revenue and cost streams which allow them to make guesses about what their profits might be.
Firms will try to formulate these expectations into specific cash flows and outlays across the time horizons that
are applicable to the particular investment good. Different investment options will typically have different
revenue and cost outlay profiles over time. So one piece of equipment might involve higher outlays in the more
near future but deliver higher returns in a later period compared to another piece of equipment that delivers the
same flow of production services but is cheaper in the near future but
In this section we introduce some introductory concepts to allow us to compare flows of funds between different
periods in the future. The reason that this is not a straightforward exercise of su
Start with a rate of interest (the cost of obtaining funds) of 10 per cent. If you had $100 now and loaned it for a
year then at the end of year 1 you would have $100 plus the interest earned which is given by the following
formula:
(12.20)
$100 + 0.10 x $100 = $100(1 + 0.10) = $110
This simple arithmetic generalises to the following model of compound interest:
(12.21)
Pt+1 = Pt(1 + i)
where Pt+1 is the amount received in period t + 1 where t is now, Pt is the amount you invest now, and i is the
nominal rate of interest.
What if you were to reinvest Pt+1 for the second year? You would expect to receive an amount P t+2 according to
the following formula:
(12.22)
Pt+2 = Pt+1(1 + i)
From Equation (12.21) we know that Pt+1 = Pt(1 + i) so Equation (12.22) can be re-written as:
(12.23)
Pt+2 = Pt(1 + i)(1 + i) = Pt(1 + i)2
We can generalise this if the period of the loan is n years to:
(12.24)
Pt+n = Pt(1 + i)n
Equation (12.24) is a compound interest formula and assumes that the interest is added (compounded) at the end
of each year. The formula gets more complicated if there are multiple compounding periods within the year. We
do not consider these complications in this textbook.
You will appreciate from the concept of compound interest that a sum invested at a positive interest rate now
will grow to a larger future nominal amount in the future. We can deploy this concept in reverse to calculate
what a sum of cash that you expect to receive at some future date is worth today. You can see that this type of
information is an essential component for a firm making investment decisions where the cash returns and
outlays are received or incurred at some future date.
In general terms, how much would you have in today’s dollars if you knew you were to receive P t+1 (that is, a
sum of cash Pt+1 next year)?
From Equation (12.21) we can see that:
(12.25)
Pt = Pt+1/(1 + i)
Consider our initial example where Pt+1 was $110 and i was 10 per cent. Equation (12.25) tells us that $110
received at the end of the year would be worth $100 now if the interest rate over the year was 10 per cent.
In this way, a firm can convert all future cash flows into current value using a generalised form of Equation
(12.25).
You can think about this in this way. If you needed cash now and knew you were going to receive $110 at the
end of this year and the current interest rate was 10 per cent then how much would you be able to sell your
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future claim on income for in the open market? The answer is $100 as long as the receipt at the end of the year
was risk free and the inflation rate was zero (complications we will consider in a later Chapter).
No-one would be prepared to give you say $105 now in return for $110 at the end of the year if the interest rate
was 10 per cent because they would be losing money. Similarly, you would be flooded with offers below $100
now if you were selling an asset (income flow) that would deliver the buyer $110 and interest rates were 10 per
cent.
We also know that the current value of a future cash flow will be sensitive to the rate of interest. Imagine that
the rate of interest was to fall during the year to 5 per cent. Then the future flow of cash of $110 would be worth
$104.76 (110/(1+0.05)). You can verify that if you were to loan $104.76 now at 5 per cent then at the end of
year 1 you would have $110. The future cash flow is less valuable now if the interest rate was to rise.
The current value of a future cash flow is called its present value (PV). The general formula for present value of
a cash flow to be received at the end of period n is:
(12.26)
Pt = Pt+n/(1 + i)n
What about the situation where the expected cash flows of varying degrees are distributed across several
different time periods? In that case, the present value of a flow at time t, P t can be written as:
(12.27)
Pt = Pt+1/(1 + i) + Pt+2/(1 + i)2 + Pt+3/(1 + i)3 + … + Pt+n/(1 + i)n
where the … refers to terms we have not written between time period t + 3 and n.
The conversion of disparate future cash flows across time into present values is generally called Discounted
Cash Flow analysis.
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12.11 Investment and the Rate of Interest
We are now in a position to consider the impact of the rate of interest on investment expenditure in more detail.
As we learned in Chapters 7 and 8, investment decisions taken by entrepreneurs form an important component
of total aggregate demand and income and as a result help explain changes in total employment.
Firms are continually making guesses about the future in terms of what the overall state of demand for their
products will be, what they are likely to receive by way of revenue if their sales match these expectations, and
what it will cost them to produce the output necessary to meet this demand.
Firms also have various choices about what products to produce and how they can produce them (for example,
choice of technique). Firms are driven by the desire to make profit and will thus make choices among different
types of productive equipment on the basis of which will contribute the most profit subject to a range of other
considerations, many of which are subjective. For example, a firm that wishes to keep good standing in the
community will probably eschew the use of equipment that is damaging to the local environment even if the use
was legal and generated more profits than other options.
Whether firms use retained profits to fund future investment or seek funds from the markets, there is a cost
involved in purchasing new capital. A firm may have retained earnings to invest. It has the choice of investing
them in new plant and equipment, or perhaps, purchasing financial assets which yield a positive rate of return
(for example, a bond). While the firm will be driven by the need to stay in its present business and therefore
defend its market share, which means it will usually want to use the funds available to it to purchase best
practice, productive infrastructure; it may, at times, hold off from upgrading its productive capital if the
circumstances are not conducive.
Investment decisions will thus depend on whether the productive asset being purchased delivers a positive return
above the cost.
We can build on our understanding of present value (PV) to advance this idea in relation to the investment in
productive capital.
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12.12 Keynes and the Marginal Efficiency of Investment
In Chapter 11 The Marginal Efficiency of Capital of The General Theory of Employment Interest and Money
(published in 1936) John Maynard Keynes developed his theory of investment based in his concept of the
Marginal Efficiency of Capital.
Keynes defined the Marginal Efficiency of Capital as:
… being equal to that rate of discount which would make the present value of the series of
annuities given by the returns expected from the capital-asset during its life just equal to its supply
price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of
these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.
His definition is difficult to understand and created some controversy, which we will touch upon here.
It is clear that he was thinking about two aspects of the investment decision: (a) the “prospective yield of the
investment” which is a “series of annuities Q1, Q2, … Qn”. These are future flows of cash associated with an
investment which the entrepreneur “expects to obtain from selling its output”. You can relate these flows to the
earlier discussion of compound interest; and (b) the supply-price of the asset which he said was the “the price
which would just induce a manufacturer newly to produce an additional unit of such assets” or in more simple
language – “the replacement cost”.
The rate of discount he was referring to is also known as the internal rate of return of a project. As we saw in
the last section, we can calculate a present value for any future cash flow stream. A net present value would be
the present value of the revenue to be received minus the present value of the costs of the project.
A positive net present value coincides with a project that earns a positive rate of return in current dollars where a
negative present value means that the project would lose money in current dollars.
The internal rate of return is the interest rate that would discount future income and cost outlays such that the net
present value was zero.
Consider Figure 12.9 which provides data for a specific investment project. In the current year, the firm has to
spend $10,000 to purchase the equipment. In subsequent years it receives the cash flows as indicated. We can
assume there is no scrap value for the equipment after Year 5.
Table 12.7
A Simple Cash Flow for an Investment Project
Year
Cash Flow
$
0
-10000
1
2500
2
3200
3
3500
4
3300
5
2500
What is the internal rate of return (IRR) for this project?
The present value of the costs are $10,000 because they are all incurred in the current year (that is, now). The
dollar sum of the cash returns is $15,000 but as we saw in the previous section, the dollar amounts cannot be
compared across time periods because of the impacts of compounding.
The present value of the flow of revenue is given by the formula in Equation (12.27). Using the data in Figure
12.9 we would write this equation as:
(12.28)
PV = $2,500/(1 + i) + $3,200/(1 + i)2 + $3,500/(1 + i)3 + $3,300/(1 + i)4 + $2,400/(1 + i)5
The internal rate of return is the discount rate (i)) that satisfies the following equation:
(12.29)
NPV= -$10,000 +$2,500/(1 + i) +$3,200/(1 +i)2 +$3,500/(1 + i)3 +$3,300/(1 +i)4 +$2,400/(1 + i)5 =0
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The solution for i requires mathematics that are beyond the reach of this textbook (for interested students we
have to solve the roots of Equation 12.29). You can use spreadsheet functions to do the task for you if you input
the relevant data.
In our case, the IRR is 15.1 per cent.
You might like to input the data into a spreadsheet and compute the present value in Equation (12.28) using a
discount rate of 15.1 per cent. You should verify that it is equal to $10,000, which is exactly the present value of
the initial outlay. The actual result you get may not equal $10,000 but this is due the approximate iterative
solutions used by the spreadsheet.
This project will be profitable if the cost of borrowing funds to fund the project (that is, the market rate of
interest) is below the IRR.
We can interpret Keynes’ concept of the MEC as being the return at the margin that a firm would expect to earn
by investing in new capital equipment. That is, it is not the market return on existing assets.
Consider Figure 12.10 which shows three investment projects A, B and C that a firm has available to it ranked
by their respective MEC. Project A has an IRR (or MEC) of 10 per cent, while Project B has an MEC of 8 per
cent and Project C has an IRR of 5 per cent.
Figure 12.4
MEC and Investment Projects
10
8
Marginal
Efficiency
of Capital
Project A
5
Project B
Project C
MEC
New Capital Expenditure $
The firm must consider how much new capital expenditure it will incur for the coming year. If the market rate of
interest is currently 9 per cent, then the firm would only be interested in investing in Project A, which means
that its capital expenditure in the current planning period will be limited to Project A.
Should the market interest rate drop to below 8 per cent, then it will be profitable to borrow sufficient funds (or
use retained earnings) and invest in both Project A and Project B. As a consequence, total investment will rise.
The firm will expand investment to Project C if the market rate of interest drops below 5 per cent.
The downward sloping MEC line that is depicted in Figure 12.10 summarises the investment response of the
firm to changes in the market interest rate.
As a result a simple model of investment emerges whereby total investment in the economy is considered to be a
downward function of the market rate of interest as in the Equation (12.30):
(12.30)
I = I0 – bi
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where I is total investment, I0 is some level of investment that is independent of the market rate of interest and b
is the sensitivity of investment to the market rate of interest, i.
When considering Equation (12.30) you should always consider what lies behind it in terms of the MEC. The
simple investment model, which says that rising market rates of interest lead to lower total investment, is based
on an assumption that all other things are equal. But as we have seen, underpinning the concept of the MEC is a
comparison between the demand-side (expected revenue) and the supply-side (the replacement cost).
In a growing economy, it is likely that aggregate demand conditions will improve at times when the market rate
of interest rises. The former will improve the revenue cash flows over time and increase the MEC for each
project. In other words, we would not observe investment falling when the market rate of interest rose because
the IRR of each project could also be increasing.
Thus it is important to avoid applying a mechanical interpretation of the concept of the MEC. Keynes, in fact,
did not think investment would be very responsive to changes in the market rate of interest, especially when the
economy was in recession or boom. Expectations formed by entrepreneurs underpinned their MEC calculations.
When the economy was in recession, entrepreneurs would become pessimistic and this would negatively impact
on their assessment of the future returns from different projects. Further, with substantial excess productive
capacity firms are unlikely to expand the capital stock even if new investment projects become cheaper as the
central bank cuts the market interest rate to stimulate demand.
The extreme optimism that typically accompanies a boom also would reduce the sensitivity of investment to
changes in the market rate of interest. With expected returns high, firms will be prepared to pay higher
borrowing costs.
We could express this enhanced optimism by a shift outwards in the MEC line in Figure 12.10 which would
make more Projects worth pursuing at a given market rate of interest.
If entrepreneurs became excessively pessimistic then the MEC line would shift inwards and fewer projects
would be deemed profitable at a given market rate of interest even if the technical aspects of the equipment was
unchanged.
For Keynes then, investment was a very subjective act and responsive to how firms felt about the economy.
Even though Equation (12.30) seems simple, the ideas underpinning it were anything but.
We consider the crucial role of expectations and what factors firms might consider when forming expectations
of future returns in Chapter 17 Keynes and Classics and modern variants.
The concept of the MEC was refined by later economists including Abba Lerner who preferred the term
Marginal Efficiency of Investment (MEI).
There were many criticisms of this approach to investment theory.
A substantial criticism focused on the logic of a downward sloping MEC line at times when involuntary
unemployment was observed. If we consider the expenditure multiplier, then aggregate demand rises by some
multiple of a rise in investment, expenditure and output rises.
If the MEC is influenced by expected future returns, then the increased national income arising from the
increased investment would logically lead to higher expected future revenue. In that case, the MEI will shift
outwards as not above which means that investment should increase as a result. This would then stimulate
further multiplied increases in aggregate demand and output and so the process would continue.
With plenty of excess capacity in the form of high unemployment, it is easy to conceive of a situation where
investment would be indeterminate as the multiplied income increases feedback into further investment as
expected returns improve. As a consequence, the firms will progressively invest in an increasing number of
projects and the market interest rate would lose all relevance.
Once again we see the importance of expectations in this approach to investment.
The response to this criticism was also varied.
One approach attacked the idea that the MEI line could be aggregated across all firms to become the aggregate
(or macro) investment function. It was argued that this “aggregate” investment line would over-estimate the
investment that would accompany a fall in interest rates. The argument noted that if the interest rate was to fall
and borrowing costs for all firms were now lower, then as all firms expanded investment in productive capacity,
the rising demand for capital goods would drive their price up which would reduce the MEC lines for all firms.
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Some economists have attempted to distinguish the MEC from the MEI along these lines, saying that the MEI is
the relationship between total investment and market interest rates when the demand effects on the price of
capital goods is taken into account.
Michel Kalecki introduced what he termed the Principle of Increasing Risk which brought together the
investment decision and the risk of increased indebtedness that firms would carry as they expanded investment.
As firms extended their exposure, the success of the marginal projects in terms of generating realised returns
became more crucial. Kalecki argued that firms would become increasingly risk averse as their debt levels rose
and this would be expressed by more sober expectations of the future returns from various projects.
Kalecki thus considered that increasing risk would thus ensure that the MEI was downward sloping with respect
to the market rate of interest.
[NOTE: MORE TO COME ON THIS]
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References
The key articles/books that outline Kalecki’s approach to profits are:
Essai d’une theorie du mouvement cyclique des affaires, Revue d’economie politique, 1935.
A Macrodynamic Theory of Business Cycles, Econometrica, 1935.
Essays in the Theory of Economic Fluctuations, 1939.
A Theory of Profits, Economic Journal , 1942.
Studies in Economic Dynamics, 1943.
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