EEP-6 Investment Prof. Tarun Das

8/9/2019 EEP-6 Investment Prof. Tarun Das

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Prof. Tarun Das, IILM EEP Session-6 1

Economic Environmentand Policy (EEP)

Session-6

Investment Multiplier And Business Cycles

Dr. Tarun Das, Professor, IILMFormerly, Economic Adviser, Ministry of Finance


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Contents of this presentation

1 . Investment function, investmentmultiplier and accelerator

2. Numerical examples

3. Types of business cycles4. Causes of business cycles5. 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 = K t = K t k t- 1Capital/output ratio (COR) = Kt / Yt Incremental capital/output ratio (ICOR)= Kt / Yt Kt = w. Yt, where w = COR = ICORIt = K t k t- 1 = w (Yt Y t- 1 ) = w Yt

The basic relationship between change of output and volume of investment is known asaccelerator principle. The capital/outputratio w is known as the accelerator.


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1 .2 Investment MultiplierInvestment multiplier is the ratio of

incremental income to incrementalinvestment.Investment multiplier = Yt / It

Yt = Ct + It = E + F Yt +It

Or, Yt - F Yt = E + It Or. (1- F) Yt= E + It Or, Yt = E / (1- F) + 1/ (1- F) It Investment multiplier = Yt / It = 1/ (1- F)

= 1/ (1-MPC) = 1/ MPS.Investment multiplier varies directly with MPC

and inversely with MPS.


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2. 1 Numerical Example: MultiplierProblem-1: Given consumption functionC=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=0.25Investment multiplier = 1/ (1-MPC) = 1/ MPS= 1/ 0.25 = 4.If investment rises by Rs.100 Crore, income risesby Rs.400 Crore. Then, consumption rises byMPC*Y = 0.75*400 = Rs.300 Crore and savingsrises by Rs.100 Crore.


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2.2 Numerical Example: ICORProblem-2: Given average real GDP growth rate

of 9% and average investment ratio of 36%,estimate ICOR. Assuming that ICOR declinesby 5% due to increase of productivity, howmuch 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 = 3.8So required investment for a growth rate of 10%

= 3.8 * 10 = 38%.


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2.3 Equilibrium Income with governmentProblem-3: Let consumption depends

on disposable income andconsumption function is given by:C=50+0.75 (Y-T). Further assumethat average tax rate is 20% andgovt 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 =GC=50+0.75 (750-150) = 500S=Y-C-T=750-500-150=100Check: 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 movementsin economic activity: such as realGDP, employment, profits etc.

Its timing is random, and to a largedegree, unpredictable.

A business cycle is identified as asequence of four phases:

1 .Recession,2.Trough,3.Boom,4.Peak


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3.2 Phases of Business Cycle1 .Contraction, Recession, Slum,

Depression (A slowdown in the paceof economic activity); A recessionoccurs if a contraction is severe enough.

A deep trough is called a slump or adepression.

2.Trough (The lower turning point of abusiness cycle, where a contractionturns into an expansion);

3.Expansion, Prosperity, Boom (A

speedup in the pace of economicactivity);4.Peak (The upper turning of a business

cycle, where an expansion turns into acontraction).


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3.3 Different phases of business cycles

Trough

Peak

ContractionExpansion

Time

variable


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3.4 Business Cycles are Irregular

In many ways, the term business cycle ismisleading. Cycle seems to imply that there is someregularity in the timing and duration of upswings and downswings in economicactivity.Most economists, however, do not think so.For describing the swings in economic activity,therefore, many modern economists preferthe term short-run economic or businessfluctuations to business cycle.


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3.5 Types of Business CyclesMain 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 11years) after Clement Juglar, comprising

four stages:1. expansion = rise in production and prices,and low interests rates.

2. crisis = stock exchanges crash and severalcompanies become bankrupt.

3. recession = decrease in price and in output,high interests rates.4. recovery= stocks recover thanks to the fall in

prices and incomes.


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3.6 Types of Business CyclesThe Kuznets infrastructural investment cycle

(15 25 years) after Simon Kuznets, NobelLaureate,The Kondratieff industrial wave or innovationcycle (45 60 years) after Nikolai

Kondratieff.The Forrester generation cycles (200 years) -after Jay Wright Forrester.The Toffler civilization cycles (1000-2000

years) - after Alvin Toffler.


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4. 1 Business Cycle (BC) variables

Business cycles are generally measured bymovements 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 Cycles-Trend in Real GDP in USA in 19 55-2005


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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 andconsumption. Observe how peaks and troughsalign and how upturns and downturns coincide.


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5. 1 Causes of Business CyclesJust as there is no regularity in the timingof business cycles, there is no reason whycycles should occur at all.

Business cycles occur due to somedisturbances, which pull the economy abovefull employment or push it below.Inflationary booms are generated by surgesin private or public spending.Similarly, a wave of optimism or feel goodfactors cause consumers to spend morethan usual and firms to build up newcapacities than necessary.


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5.2 Causes of Business CyclesRecessions or depressions can be caused bythe same forces working in reversedirections.

A substantial cut in government spending ora wave of pessimism among consumers andfirms may cause the output of all types of goods and services to fall. Another possible cause of recessions andbooms is monetary policy.

A firm faced with high interest rates maydecide to postpone building a new factory.Households may be lured by cheap housingloans, and construction activities may boom.


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5.3 Political Theory of Business CyclesThe partisan theory of business cyclesuggests that cycles result from thesuccessive elections of administrations withdifferent policy regimes.Regime A adopts expansionary policies,resulting in growth and inflation, but isvoted out of office when inflation becomesunacceptably high and hurts everybody.The replacement, Regime B , adoptscontractionary policies reducing inflation andgrowth, and the downwards swing of thecycle. It is voted out of office whenunemployment is too high, being replacedby Party A.


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6. 1 Co-movement of variablesMany 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 alsorise, and inflation may rise if the expansion istoo brisk.Conversely, during recession, outputs of goods and services falls, employment falls,construction falls, and prices of consumergoods and wages also fall.Recession is a period when a broad range of economic indicators falls for a sustainedperiod, roughly at least half a year.


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6.2 Cyclical behavior of macro economicvariables and BC indicators

According to Direction of change : variables canbe classified as procyclical, countercyclical oracyclical.Procyclical - Variables have positive correlation.They usually increase during booms anddecrease during recessions .Consumption,investment and employment are stronglyprocyclical .Countercyclical- Variables have negativecorrelation. Unemployment is countercyclical.

Acyclical- Variables have zero correlation,implying no systematic relationship to thebusiness cycle . capital stock is acyclical.


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6.3 Cyclical behavior of macro economicvariables and BC indicators

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

Leading Indicator : which occurs ahead of theoccurrence of business circle variable.

Coincident Indicator : which move up and downalong with the business cycle variable.

Lagging Indicator : which follow the businesscycle variable after some time lag.


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6.4 Leading Indicators

New employment New orders for consumer durable goodsStock IndexNew orders for plant and equipment

Building permits for private housesDeliveries by CompaniesIndex of consumer confidence

Index of business confidenceInflationMoney growth rate (M2)


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6.5 Coincident Indicators

Nonagricultural employment Index of industrial productionPersonal income

Manufacturing and trade sales


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6.6 Lagging Indicators

Wage ratesRate of inflationConsumer credits

Lending ratesOutstanding loans


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6.7 Cross Classification of IndicatorsItems Direction of

changeTime of occurrence

Industrial output procyclical coincident Capacity utilization procyclical coincident Employment procyclical coincident Unemployment countercyclical coincident Inflation rate procyclical laggingCorporate profits procyclical coincident

Short-term interest procyclical laggingShare price procyclical LeadingCapital stock acyclical lagging


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Thank you

Have a Good Day

EEP-6 Investment Prof. Tarun Das

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