Let us make an in-depth study of Investment. After reading this article you will also learn about: 1. Components of Investment 2. Investment Analysis 3. Effect of Income Tax on Investment.

Components of Investment:

Investment spending is of three types:

1. Fixed investment — business purchases of new plant, machinery, factory buildings and equipment.

2. Residential investment — construction of new houses and flats.


3. Inventory investment — increases in stocks of goods produced but not sold. This is known as working capital and consists of stocks of raw materials, manufactured inputs and final goods awaiting sale. Business firms hold two types of inventories.

They hold finished goods inventory because production and sales do not always coincide. And they hold inventories of raw materials and semi-finished goods (called work-in-progress) in order to ensure uninterrupted production. For example, a publisher holds sufficient stock of paper so that the required number of copies of a textbook can be supplied when the old edition is out of print.

At the macro-level, the volume of investment is the joint outcome of three factors:

(1) investment demand, decisions made by business firms about the amount of investment to undertake;


(2) supply of saving, which depends on the decisions made by consumers about the amount to save; and

(3) supply of investment goods by the industry producing capital goods.

The economy reconciles the decisions of the various groups with the interest rate and price of capital goods.

Two points may be noted in this context:


(i) If business firms seek to invest more than consumers are willing to lend, the interest rate rises enough to depress investment and stimulate saving to restore saving-investment equality.

(ii) If business firms want to invest more than the suppliers of capital goods want to produce, the price of capital goods will rise.

As a result investment demand will fall and the supply of capital goods will rise, again to the point of equality.

Investment Analysis:

Investment is the flow of newly created capital goods:

It = ΔKt – Kt-1

Investment may be gross or net. Gross investment is net investment plus depreciation or net investment is gross investment minus depreciation.

The overall level of investment depends on three factors: (i) the investment demand of firms, (ii) the funds available for market, and (iii) the volume of investment goods produced. Interest rates and the prices of investment goods move to balance the three factors.

In this chapter we study two types of business investment, viz., business fixed investment (i.e., investment in plant equipment, machinery and structures) and inventory investment.

The focus is on three basic points:


1. The inverse relation between the interest rate and the volume of investment.

2. The shift of the investment function due to technological progress or tax cut which improves profit prospects.

3. Rise of investment during upturns of the business cycles and fall of investment during downturns (slumps or recessions).

Business Fixed Investment:

Business fixed investment — i.e., capital expenditure made by business for buying machines for producing saleable goods in the future — constitutes the bulk of investment spending in a modern market-based economy.


Fixed investment refers to purchase of those capital goods which are durable in nature, i.e., which will be used for a number of years from the-time of purchase or acquisition. It is a long term investment. Inventory investment, on the other hand, involves short term decision because inventories of raw materials will be used ere long and inventories of finished goods will be sold sooner or shortly later.

Effect of Income Tax on Investment:

Corporate profit taxes influence firms’ incentives to accumulate capital. The corporate income tax is a tax on corporate profits. This means that firms would be sharing a portion of their profits with the government. Still it will be judicious on the part of a firm to invest if the rental price of capital exceeds the cost of capital and to disinvest if the rental price falls short of the cost of capital. A tax on profits would not alter investment incentives and thus the volume of investment.

However, corporate taxes affect business decisions adversely due to the fact of depre­ciation. During inflation replacement cost of capital is greater than historical cost. This means that corporate tax tends to underestimate the cost of depreciation and overestimate profit. Thus a tax is levied on profit even when real profit is zero. This makes owning capital less attractive. For this reason corporate income tax discourages investment.