Investment

I. THE AGGREGATE INVESTMENT FUNCTIONRobert Eisner

BIBLIOGRAPHY

II. THE INVESTMENT DECISIONJack Hirshleifer

BIBLIOGRAPHY

I. THE AGGREGATE INVESTMENT FUNCTION

By “aggregate investment function” we usually mean the relation explaining producers’ net acquisition of the capital goods (buildings, equipment, and inventories) that are part of the process of production in the economy as a whole.

The major importance of investment is twofold. First, output in the future depends upon the maintenance of existing means of production. Economic growth, i.e., the increase of the rate of output, depends largely upon investment in excess of the wearing away of existing means of production. Second, the maintenance of “full employment” or, in general, the full utilization of existing resources, requires that aggregate investment plus aggregate consumption equal the total output that would be produced if all individuals who wished to work could find employment. The first aspect of investment was stressed by the classical and neoclassical economists and, usually under the designation “capital accumulation,” by Marx and his followers. The second aspect has received major attention in recent years, in large part as a consequence of the work and influence of John Maynard Keynes (1936).

Investment and saving

In considering the aggregate investment function, two related issues are generally distinguished: the determinants of investment by individual business units, and the determinants of saving, that is, abstention from current consumption, by those who earn or receive income. By usual accounting definitions (with appropriate adjustments of government accounts), the sum of investment by all producing units must, in fact, be identically equal to the sum of saving by all consumer or income-receiving units. Hence, separate consideration of these issues may seem paradoxical. But separate consideration is meaningful because actual aggregate investment or saving is the resultant of two sets of forces, those related to producers’ desires to obtain goods and those related to consumers’ preferences to forgo the opportunity to obtain goods. The analogy to supply and demand curves is apt and helpful here. The saving function indicates the supply of financial resources that producers may apply to the purchase of capital goods, and the investment function indicates the demand by producers for financial resources with which to buy capital goods. The actual total of investment or of saving (the totals will be identical) is determined by the intersection of the saving and investment schedules, the intersection being the point of equality of these two functions.

With this approach we are able to set to one side the factors affecting investment that relate to the supply of saving, i.e., to the saving or consumption function. Analysis of the investment function itself may be concerned with the rates of investment that would be consistent with various sets of values of the variables that affect the rate of investment, regardless of consistency of these values with the consumption or saving function; or it may concern what could be considered the inverse of the investment function, that is, the sets of values of the variables that would determine a rate of investment equal to some predetermined rate of saving given by the saving function or by policy considerations.

investment demand

Investment demand may be seen as determined by the interaction of the factors that affect the expected profitability of investment, on the one hand, and by those that affect the interest rate (or some other, more appropriate measure of the cost of capital), on the other hand. The expected profitability of a contemplated unit of investment is best viewed as that rate of discount for which the sum of resultant additional expected receipts and expenditures, including the purchase cost, the yield, and the ultimate sale or salvage return, is zero. The relevant cost of capital for the firm that already has command over the resources necessary to finance investment is the rate of return, appropriately adjusted for any differences in risk, that may be enjoyed on alternative uses of these resources. For the firm that must secure command over such resources, the relevant cost of capital relates to the cost of securing funds, again adjusted for the resulting changes in the risk position of the firm. While the cost of capital may therefore differ, depending, among other things, on whether firms are borrowers or users of their own finances, one may wonder whether this distinction carries much weight in the aggregate, at least in economies with well-developed financial markets.

The investment demand function may then be reduced to a two-variable relation indicating the rate at which producers would wish to acquire capital goods per unit of time as a function of the rate of interest. Since, at a given rate of interest, producers would wish to acquire all capital goods they would have wished to acquire at higher rates of interest as well as some additional capital goods that are profitable at the given rate, investment demand is presumed to be higher (or at least not lower) the lower the rate of interest.

A stable relation between investment demand and the rate of interest presumes, for one thing, however, a stable relation between “the rate of interest” and the relevant cost, appropriately discounted for risk, of the financial resources required for investment. Further, it requires that the expected marginal profitabilities of investment opportunities remain unchanged.

Largely following Keynes, many economists have stressed, since the great depression of the 1930s, that the rate of interest is not the critical variable determining investment demand. Rather, the critical variables are those determining the expected profitability of investment, especially at the margin, or what is called the “marginal efficiency” of investment. Their view is that investment demand is fairly in elastic with respect to the rate of interest. This means that changes in the rate of interest bring about proportionately small changes in investment demand. The logical corollary of the argument is that the expected profitability of additional investment (again, the marginal efficiency of investment) declines rapidly as the rate of investment increases. Investment demand, however, is considered to be highly variable as a result of changes in factors other than the rate of interest, either because of high elasticity of investment demand with respect to these other variables or be-cause these other variables themselves, unlike the (long-term) rate of interest, are subject to great variability.

These views are represented in Figure 1 , which shows three investment demand curves, all depicting investment demand (I_D) as a declining, relatively inelastic function of the rate of interest (i).

It may be noted readily that the variation in investment demand along any one investment demand curve that might be occasioned by variation of the rate of interest, as among i₁, i_2,; and i₃, is relatively small compared with the variation in investment demand that would be occasioned by shifts from one investment demand curve to another. Thus, the differences within the sets (A, B, and C), (D,E, and F), and (G,H, and K) are relatively small compared to the differences between any one of these sets and any other. Keynes and “Keynesians” have concluded that, since movements of the investment demand curve are likely to be quite large relative to the changes in investment demand that may be induced by movement along any one investment demand curve, the effectiveness of monetary action, which might alter the rate of interest, is severely limited.

Role of expectations. The factors affecting the expected profitability of investment, that is, the factors indicating which of the investment demand curves in Figure 1 is relevant, may be in part objective and in part subjective. The objective factors affecting expected profitability are technology (the current and future parameters of the production function), relative prices of factors of production (both current and future), and future demand for product. If decision makers could know these with certainty, the investment function would be fully determined. However, these underlying objective elements influence investment demand to the extent and in the manner that they are subjectively perceived by decision makers. It may be argued that in “equilibrium” the objective elements must be determining; otherwise we should have the paradox of entrepreneurs repeatedly acting on the basis of expectations that are persistently falsified by events, and never learning from the unhappy experience. Nevertheless, the equivalence of subjective expectations and objective conditions is limited by imperfect knowledge, risk, and uncertainty, which are endemic to the investment process. The resultant partial independence of expectations from objective factors must be accorded a major role in our inability to use objective data to predict more than a minor fraction of short-run variations in the rate of investment.

With the production function, relative prices, and demand for output constant, one may expect a constant demand for capital stock. Producers’ demand for capital goods, that is, investment demand, would consist only of demand to replace capital goods used up in production. Positive net investment demand—demand for capital goods in excess of depreciation—must depend upon expected changes in the production function, prices, or demand for output relative to their values in determining the existing capital stock.

Because of the imperfection of information and heavy discounting for risk and uncertainty, one may expect entrepreneurs to delay action based on expected changes in the determinants of the optimum capital stock until these changes have become very clear. In practice this may mean waiting at least until changes have taken place and, particularly in the case of unanticipated changes, waiting until changed conditions have persisted long enough to generate confidence in their relative permanence. In an uncertain world a good rule of thumb may be to act as if the future will be like some weighted average or projection of the past. Yet it must be recognized that entrepreneurs attempting to maximize profit must be guided ultimately by their view of the future, however much their view of the future may be conditioned by the past and present. With this caveat, we may look to changes in current values of relevant variables for determinants of investment demand. Let us consider in turn the production function, relative prices, and the demand for output.

Changes in the production function. Changes in technology, which we may consider to be changes in parameters of the production function, will influence investment if they alter the composition or total of capital goods desired to produce a given output. Changes in the composition of desired capital will serve to make existing capital goods obsolete and may generate an investment demand for purposes of their replacement. A change in the production function that changes only the composition of desired capital will have a “one-shot” effect on investment. Once alteration in the composition of capital goods is completed, the rate of investment will be the same as it was previously.

A change in the production function that alters the desired ratio of capital stock to output is likely to have a continuing effect on investment. Again, any accompanying change in the desired or “equilibrium” composition of capital may generate investment until the existing capital stock has experienced the desired transformation. Such investment may be negative in amount if the capital–output ratio of the new equilibrium is less than the capital–output ratio of the previous equilibrium. But in addition, the investment generated by a change in the desired capital–output ratio must be such as to permit the attainment of the new desired stock of capital for any given level of output. If output is constant, a change in the capital–output ratio will also have merely a “one-shot” effect on investment, which will end when the new capital–output ratio is attained. If output is growing, which is probably the more likely case, an increase in the capital–output ratio will increase the equilibrium rate of investment, for more additional capital will then be required for each additional unit of output. Conversely, a decrease in the capital–output ratio will lower the amount of investment associated with any given rate of growth of output.

Changes in relative prices. Changes in relative prices may have effects analogous to those induced by changes in the production function because they may induce changes in either the composition or total amount of desired capital (or in both) associated with any given level of output. Changes in relative prices may involve changes in relative wages or other forms of remuneration for different types of labor; changes in the relative prices of other nondurable inputs, such as electric power or gas heat; changes in relative prices of different kinds of capital goods; changes in wage–price ratios; and changes in rates of interest or other ratios of the current prices of goods and services to corresponding prices expected at future dates.

It is probably most useful to think of relative prices as affected by supply conditions. Thus, if individuals come to supply more or less of a certain type of labor, the wage for that type of labor will change. Similarly, changing degrees of monopolistic or oligopolistic power may alter the prices charged both for goods and for labor services. Finally, preferences for present and future consumption may be altered by changes in individual choices or by changes in the distribution of income among those exercising such choices, so that the supply of saving is affected. This might manifest itself in changes in rates of interest or in other measures of the relative prices of present and future goods.

Role of interest rates. Alteration in the relative price of current and future goods, frequently measured, in professional-economics shorthand, by “the rate of interest,” merits further consideration. A lower rate of interest, by raising the present discounted expected prices of future output (and input) relative to current input (and output), tends to increase the demand for capital goods generally and, in particular, to increase the demand for longlived capital goods. Long-lived capital goods are current inputs that promise consequent outputs far into the future. Longer-lived capital, however, must of necessity involve higher ratios of capital to output, as long as we are dealing with economically relevant choices. Capital goods that offer the prospect of lower outputs now as well as in the future would never be chosen. Hence an interest-induced shift to longer-lived capital must be a shift to capital with relatively higher expected outputs in the distant future but with relatively lower current output and lower expected outputs in the near future. Since longer-lived capital is associated with smaller current output, a shift to longer-lived capital implies a higher capital–output ratio. Conversely, higher interest rates will militate for a choice of shorter-lived capital and lower capital–output ratios.

It may be further expected that given changes in the rate of interest will have a greater effect on those categories of investment involving relatively longer-lived assets, since changes in the rate of interest will have a greater relative effect on the present values of expected returns from longer-lived assets. Thus, for any given change in the rate of interest, the effect on inventory investment may be expected to be small compared with any possible effect on investment in equipment and, a fortiori, in plant. This must be qualified, however, by the recognition that changes in the short-term rate of interest are what are relevant to immediate effects on inventory investment and that the short-term rate of interest, both in theory and in fact, will fluctuate more than the relatively stable long-term rate which is relevant to fixed investment.

It is this last consideration that has led many economists to conceive of variations in rates of interest as having only a very limited potential for affecting investment. For if it is from the long-term rate that any substantial influence on investment must stem, it is to possible changes in the long-term rate that we must look. But in a free market the long-term rate must reflect expectations of

future short-term rates. Investors would hardly be willing to hold long-term securities at prices that implied rates of return lower than their expectations of returns from corresponding successions of shorter-term maturities. In the face of expectations of higher future short-term rates, investors would strive to sell long-term securities until their prices were depressed sufficiently to raise their yields to equality with a weighted average, appropriately adjusted for risks, of current and expected future short-term rates. But this would mean that action by the monetary authority to reduce short-term rates in a recession, for example, could have only a small effect on long-term rates as long as investors continue to anticipate higher short-term rates when the recession is over. Hence, action by the monetary authority to stimulate investment would be stymied by its inability to bring about any substantial reduction in long-term rates.

It is generally suggested that this problem is asymmetrical, in that the monetary authority should always be able to raise interest rates sufficiently to choke off an excess of investment, but it may be argued that something analogous may take place to prevent unlimited increases in the rate of interest. For prospective borrowers might find new flexibility in trade credit and other forms of “near money” when faced with rises in short-term rates above the convenience value of that particular form of bank credit generally known as money.

The role of risk. Once we admit that decision makers are concerned not merely with the mathematical expectation of expected returns but also with maximization of some preference or utility function such that a cost is attached to risk, it becomes clear that investment may be increased by a reduction of the risk faced by the investor. A project promising a 10 per cent return with certainty might be undertaken by a private investor who would reject a project offering a .9 probability of a 15 per cent return along with a .1 probability of a bankrupting, 35 per cent loss, although the mathematical expectation of the latter project is also 10 per cent.

This suggests that investment may be stimulated by two kinds of actions by government. In an economy in which investment is undertaken by privately motivated business, government could undertake measures to reduce the risks confronting the investor. This would, incidentally, argue against countercyclical monetary policy, which would have the effect of increasing uncertainty as to future interest rates. Government intervention to reduce risk facing the individual would be justified where the true risk to society is less than that to the individual.

In such cases, however, it may be preferable for government itself to undertake the investment rather than endeavor to find an appropriate subsidy or insurance scheme to induce private investment to do so. This issue is inevitably a major one in the case of underdeveloped economies requiring a large amount of interrelated or complementary investment and in the case of major new industries. It is noteworthy that in both of these instances government investment or subsidy has in fact frequently been undertaken. In the United States reference may be made particularly to railroads, commercial aviation, and atomic energy.

In view of the likelihood that risk will be viewed as cumulative over time, so that longer-term projects tend to be viewed as more risky than shorter-term projects, reduction in riskiness will tend to operate in roughly the same manner as a reduction in the rate of interest. It would increase the capital–output ratio and bring about both an initial increase in investment and a continuing increase, to the extent that demand is growing.

Changes in demand. Finally, let us consider the role of changes in demand. Changes in the composition of demand for output will, to the extent capital is specific to particular outputs, generate changes in the desired composition of capital stock. This in turn implies net investment, or the addition of capital at a faster rate than normal replacement, unless the adjustment process is no faster than the wearing out of existing capital. The portion of depreciation charges which represents an allowance for normal obsolescence will tend to include the effects of a changing composition of demand that causes obsolescence of output-specific capital. A more rapid rate of change in the composition of demand may conceivably result in increasing depreciation charges, to reflect consequently more-rapid obsolescence. This would then involve an increase in gross investment which, however, would not constitute a corresponding increase in net investment.

It is important to recognize the possible extent of changes in the composition of demand. A major source of change is geographical movement. People migrating from Mississippi to Illinois or California, or from Amsterdam to Australia, generate an additional demand for services that are particular to their new locations. Housing and public services are, of course, major and conspicuous examples. Idle or excess capacity in one region does not preclude a demand for capital to provide new capacity in another region.

Changes in the rate of aggregate demand are very likely to be of prime importance in the aggregate investment function. Except for limiting effects due to excess capacity or to reductions in the capital intensity of production, an increase in aggregate demand must generate an increased demand for capital stock. In equilibrium terms, the faster the rate of growth of aggregate demand, the greater the rate of investment demand. Indeed, as long as the capital–output ratio remains unchanged, the absorption of a constant proportion of output in investment (a constant ratio of saving to income) requires a constant per cent rate of growth of output and, in turn, of investment itself. To sustain a greater relative rate of investment, there must be a proportionately faster rate of growth of output. Thus, the rate of growth, frequently seen by the classical economists as the essential result of investment, may be viewed, as well, as the critical determinant of investment.

It may readily be calculated that a rate of growth of output of some 4 per cent per annum would account for net investment equal to some 8 per cent of output, if the capital–output ratio took on the not unreasonable value of 2. But in the United States, for example, this would constitute more than 50 per cent of gross private domestic investment. A reduction of the rate of growth of output from 4 per cent to 3 per cent while maintaining the same capital–output ratio would entail a reduction of investment for purposes of expansion from 8 per cent of output to 6 per cent of output and would thus imply a reduction of gross investment of a full 13 per cent—from 15 per cent of output to 13 per cent of output. Conversely, an increase in the rate of growth from 4 per cent to 6 per cent per annum would require, if the capital–output ratio were unchanged, an increase in investment by almost 30 per cent—to 19 per cent of output.

The argument that investment is very largely dependent upon rates of growth relates to the relative magnitudes of effects due to admissible fluctuations in rates of growth and those due to other factors, but it cannot properly be argued that growth-induced investment is independent of these other factors. Thus, the technology or the rate of interest might be such that output would be produced with virtually no capital. Then fluctuations in the rate of growth of output would have little effect on the demand for capital and investment. However, given the capital–intensive methods of production and the fairly stable long-term interest rates associated with advanced economies, there is considerable reason to believe that any major variability in investment must be associated with changes in the relation between demand and capacity in the short run and with changes in the rate of growth in the long run.

Asymmetry has been noted with regard to the determination of positive and negative net investment. In both cases, it has been argued, there is some form of constraint that sets bounds for the rates of investment attainable (Hicks 1950). In regard to positive investment, the limitation (an upper bound) is set by the amount of capacity available to create producers’ goods. In regard to negative net investment, the limitation (a lower bound) relates to the speed at which existing plant and equipment can be worn out and inventories can be disposed of, with or without conversion to a form acceptable to nonproducers. The upper bound is usually felt to be sufficiently high to permit a substantial investment boom if increases in aggregate demand or other factors are such as to bring about a great expansion of investment demand. A depression-induced fall in investment demand is frequently held, however, to run quickly into a “floor” to actual investment such that an economic slump, while cushioned, is prolonged by limitation on the rate at which excess stocks of capital can be worked off.

A general formulation of the investment function would probably replace upper and lower bounds by a dynamic adjustment process, subject to cost functions and to the usual maximization criteria by which producers strive to react to changes in their demand for capital. A critical and not implausible element in this dynamic system would be an equation that shows the cost of changes in the capital stock, within relevant ranges, to be an increasing function of the speed at which changes are accomplished (Eisner & Strotz 1964). The costs of transferring resources to producers’ goods industries in the face of a boom may become increasingly high and eventually prohibitively high, thus constraining the boom and, if the boom can feed only upon itself, setting the stage for its collapse. In the downturn, the costs of speedy liquidation of assets, recognizing the alternative of more-gradual sale or realization of returns from production in the future, may be such as to curtail even more sharply the rate of disinvestment.

One advantage of this more general formulation is that it makes entirely separate approaches to the study of inventory investment and to the study of investment in plant and equipment unnecessary. Unintended investment, long recognized as an important component of inventory investment, may also be a component of investment in plant and equipment, although the parameters of underlying relations may be such that the role and volatility of unintended investment are significantly different in the two categories. While an increase in sales expected to be “permanent” is likely to bring about inventory investment until a new, consequently higher level of inventory stocks is attained, an unexpected increase in sales will have, as an immediate effect, inventory disinvestment. With no planned increase in output, the unexpected increase in sales must be met out of existing inventory stocks. This initial, unintended disinvestment is then seen to give way to intended investment, to restore a desired stock of inventories. However, a similar analysis can be made with respect to investment in plant and equipment. An unexpected increase in sales will, when followed by an increase in output, result in a more intensive utilization of fixed capital and consequently more-rapid depreciation. Thus, the real capital stock of plant and equipment would be reduced by the unexpected increase in sales, just as was the stock of inventories. This initial, unintended disinvestment in plant and equipment would also give way to positive, intended net investment, in order to restore a desired capital–output ratio.

If technical factors (the nature of the production function) curb the possibility of added real depreciation of capital as a consequence of increased output with the existing capital stock, the analogous treatment of unintended investment in inventories and capital stock may still hold fairly clearly in the case of unexpected decreases in sales. Just as production plans may be executed in the face of a drop in sales, causing unintended inventory investment, so plant and equipment construction and purchase may continue, once initiated, in the face of a decline in sales, even though the additional plant and equipment is redundant. Thus, in a sense very similar to that relating to inventories, total investment in plant and equipment proves more than sufficient to provide the capital stock desired in the light of the new level of sales, and there is (temporary) unintended investment.

Empirical studies

Empirical investigation of the investment function has sometimes involved analysis of relations between time series of aggregative data for an entire national economy. More often, however, investment studies have focused on relations, usually also estimated from time series, within particular industries. Recently, increased attention has been given to cross sections of data for individual firms. Some work has also been done with time series data of individual firms.

Explanatory variables in empirical studies have included current and past output, sales, profits, stock yields, interest rates, depreciation charges, stocks of capital, age of capital, capacity, prices of output, prices of labor and of capital goods, “liquidity,” value of the firm, and a number of measures of expectations. Investigators have tended to find substantial positive correlations between investment and profits but less certain association between investment and the rate of interest. Tests and estimates of crude forms of the acceleration principle—that the connection between capital and output leads to prime dependence of investment on the rate of change of output—have frequently produced negative results.

A number of recent studies, with varied sets of data, have reported meaningful results with distributed lag formulations of the acceleration principle and of similar capital stock adjustment or capacity adjustment models. It has also proved possible to reinterpret the findings of earlier studies to fit this mold (Eisner & Strotz 1964). In particular, classic work of Tinbergen (1938-1939) and major studies of Klein (1951), purporting to find in profits a prime determinant of investment, can be shown to confirm equally well (or better, depending on one’s a priori model) the role of changes in output or the relation of expected demand to capacity. Chenery (1952) obtained good fits for industry time series in relations involving both single first differences of output and a capacity adjustment term. His “capacity model” made the change in capacity in any period some fraction of the difference between desired capacity, which depends upon output, and actual capacity. Koyck (1954), also working with industry time series data, secured positive results with a distributed lag formulation in which coefficients of previous changes in output were assumed, after a certain number of lags, to take on the form of a decaying geometric progression, with the common ratio for successive coefficients estimated from the data. Interestingly, he noted that the acceleration effects were more marked in relatively expanding industries, and in expansionary periods rather than in those of contraction. Meyer and Kuh (1957), working primarily with cross-section data of individual firms within industries, reported positive associations both for profits and for “liquidity” variables and acceleration variables, with the former more important in periods of recession. Eisner (1960), in his examination of a distributed lag accelerator in cross-section data, has reduced profits to the role of a proxy variable for the pressure of demand on capacity. He has reported (1963) that accelerator components maybe seen more clearly, and presumably may be better estimated, by isolating “permanent” elements in the sales and output variance to which firms may be expected to respond.

Estimates of inventory–investment relations have been bedeviled by neglect or inability to distinguish between unintended and intended investment. Essentially, increases in anticipated output or sales, as measured by new orders, have been found to be positively correlated with inventory investment. Unexpected changes in sales, as measured, for example, by differences between actual and anticipated sales, show some negative relation to inventory investment. However, the two elements are difficult to separate, since changing sales and output themselves clearly affect expectations and consequent production decisions.

Direct estimates of the aggregate investment function, it is only fair to report, are still in an early, experimental stage. Estimates derived from time series or cross sections at a less than economywide level are probably poor substitutes for direct estimates. For one thing, it is far from clear that variances and covariances between relevant variables at a microeconomic level or within particular industries bear sufficiently similar relation to variances and covariances between relevant expectational variables at the macroeconomic level. Is there, after all, any reason why a firm experiencing an increase in its sales relative to sales of other firms in its industry or even to sales in the economy should form the same expectation about future demand as it would if the increase were part of a general aggregative increase? But what is more, one must beware of ever dangerous fallacies of composition in dealing at less than aggregative levels. It remains possible, after all, that changes in demand for individual firms and whole industries may determine investment in those firms and those industries, while investment in the economy as a whole is fairly rigidly contained by the supply of saving.

Policy implications

Policy recommendations regarding investment depend in part, of course, on the preference functions of those making the recommendations. Under conditions of full employment, which are usually assumed to obtain in socialist economies but are considered less general in capitalist economies, a higher rate of investment at any point of time implies less current output for consumer use; it also implies a higher rate of growth and, hence, more future output. With less than full employment, a higher rate of investment is likely to cause increased current consumption, as well as increased future output. Decisions as to allocation of resources to provide for current consumption or for future output may be shaped by market forces, reflecting individual (including business) preferences and the existing distribution of income or, more generally, the existing distribution of control over resources. Or these decisions may be made by some central planning authority, reflecting its own preferences or some function of what are conceived to be the preferences of individuals in the society. No matter how the decisions are made, they should be influenced by the expected productivity of investment which, as we have observed, largely determines the investment function.

In an economy where the physical means of production are privately owned and are acquired for purposes of private profit, some additional issues arise. First, decisions as to the rate of investment and the distribution of investment between physical goods and human skills become decisions affecting directly the distribution of income and wealth. Second, the issue of investment becomes intimately intertwined with the question of maintenance of full employment and, hence, with the essential efficiency of the economic system.

Distributional considerations aside, policy recommendations regarding investment in a capitalist economy should be based closely on one’s view of the investment function. If investment is considered highly interest elastic, it may appear reasonable to allow free rein to individual and business saving propensities and to rely upon the rate of interest to equate investment demand and saving at reasonably full employment. This would leave the rate of economic growth at whatever level is consistent with these saving propensities, given the distribution of income, role of risk, and existing institutional arrangements—;and the basic natural and technological constraints.

If investment is considered fairly inelastic with respect to the rate of interest and if full-employment saving propensities appear high relative to investment demand, various recommendations for government action come to the fore. There is usually general agreement that, at the very least, monetary policy should be directed at keeping interest rates as low as possible. In addition, in capitalist countries a number of direct fiscal measures have been proposed and applied, chiefly involving some form of increased or accelerated depreciation allowances for tax purposes and direct tax reductions or subsidies dependent upon investment.

The effects of these fiscal measures would appear to depend in part on companion fiscal policies as well as on the nature of the investment function. The direct effect on investment stemming from higher earnings by business corporations should be relatively small unless general principles of profit maximization prove irrelevant. Firms striving to maximize profit should not invest more when earnings are higher, unless their expectations of profit stemming from such additional investment are increased. If the various tax benefits to investment are accompanied by increased taxes elsewhere in order to keep government revenues constant, there is no presumption that aggregate demand will be increased and, therefore, no justification in this direction for expectations of increased profitability from additional investment. Tax benefits or subsidies to investment unaccompanied by other compensating increases in taxes, however, should result in an increase in aggregate demand. For while firms may not raise their own expenditures, the increase in earnings will be reflected in higher dividends or higher values of corporate shares or will be passed on in lower prices, in any event raising appropriately defined real disposable income. The consequent increase in aggregate demand would generate increased demand for capital stock. Investment would then be accelerated until this larger capital stock is acquired. Maintaining the increase in the rate of investment, however, would necessitate further increases in the desired capital stock, such as might be generated by an increase in the rate of tax benefits or subsidies associated with investment.

There is another effect of the usual fiscal benefits related directly to investment. This is to raise the expected profitability of investment for any given demand by making capital goods more attractive relative to other factors of production. The magnitude of this effect may be restricted by limitations of factor substitutability, which would underlie an interest-inelastic investment demand schedule. Thus, a given benefit may raise the expected profitability of all prospective investment by, say, 20 per cent over a five-year period; but if the elasticity of investment demand is only .3, this would raise investment by only 6 per cent. However, to the extent that more capital–intensive methods of production are adopted as a result of tax benefits or other subsidies to investment, the amount of investment required to maintain any given rate of output would be increased, and more investment would thus be generated, year after year, to provide for whatever increases in demand and output are forthcoming.

To those who see investment demand as determined largely by increases in the demand for output, appropriate fiscal measures for raising investment would entail repeated cuts in taxes or increases in government expenditures, so that aggregate demand would continue to grow. Action to bring about repeated increases in aggregate demand would not only sustain investment and employment but would also tend to insure that the growth of the economy be limited only by the growth in capacity permitted by technology and by the increase in supply of factors of production—of labor and capital—under conditions of full employment.

Critics of such a policy might offer as their main objection that it would be difficult, if not impossible, to provide adequate increases in demand without generating chronic, and perhaps accelerating, inflation of prices. This would entail not only serious inequities in the distribution of real income but also losses of efficiency in the productive system that might imply a lower output with full employment than could be obtained with somewhat less than full employment but with the more efficient allocation of resources provided by a stable price system. Counterarguments in favor of governmentally induced increases in demand include the insistence that price inflation can be kept mild enough to avoid threats to efficiency and that the distributional effects of inflation are not necessarily bad (unless one views the current income distribution as necessarily the best) and can in any event be compensated for by other fiscal measures. It is further argued that increased government expenditures on various kinds of social investment (education, research, urban renewal) may actually increase efficiency, as well as provide a more equitable distribution of the benefits of social production and social living.

Robert Eisner

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Dean, Joel 1951 Capital Budgeting: Top-management Policy on Plant, Equipment, and Product Development. New York: Columbia Univ. Press.

Dieterlen, Pierre 1957 L’investissement. Paris: Riviere.

Domar, Evsey D. 1948 The Problem of Capital Accumulation. American Economic Review 38:777–794.

Eisner, Robert 1960 A Distributed Lag Investment Function. Econometrica 28:1–29.

Eisner, Robert 1963 Investment: Fact and Fancy. American Economic Review 53:237–246.

Eisner, Robert; and Strotz, Robert H. 1964 Determinants of Business Investment. Pages 59–233 in Commission on Money and Credit, Impacts of Monetary Policy: A Series of Research Studies Prepared for the Commission on Money and Credit. Englewood Cliffs, N.J.: Prentice-Hall.

Haavelmo, Trygve 1960 A Study in the Theory of Investment. Univ. of Chicago Press.

Hicks, John R. (1939) 1946 Value and Capital: An Inquiry Into Some Fundamental Principles of Economic Theory. 2d ed. Oxford: Clarendon. → See especially Parts 3 and 4.

Hicks, John R. 1950 A Contribution to the Theory of the Trade Cycle. Oxford: Clarendon. → See especially Chapters 4, 5, 6, and 10.

Jorgenson, Dale W. (1963) 1965 Capital Theory and Investment Behavior. Pages 366–378 in American Economic Association, Readings in Business Cycles. Homewood, I11.: Irwin. → First published in Volume 53, No. 2, of the American Economic Review.

Kalecki, Michael 1954 Theory of Economic Dynamics: An Essay on Cyclical and Long-run Changes in Capitalist Economy. New York: Rinehart.

Keynes, John Maynard 1936 The General Theory of Employment, Interest and Money. London: Macmillan. → See especially Book 4. A paperback edition was published in 1965 by Harcourt.

Klein, Lawrence R. 1951 Studies in Investment Behavior. Pages 233–277 in Conference on Business Cycles. New York: National Bureau of Economic Research. → A paper delivered at a conference held in New York City in 1949.

Koyck, M. 1954 Distributed Lags and Investment Analysis. Amsterdam: North-Holland Publishing.

Lutz, Friedrich A.; and Lutz, Vera C. 1951 The Theory of Investment of the Firm. Princeton Univ. Press.

Masse, Pierre (1959) 1962 Optimal Investment Decisions. Englewood Cliffs, N.J.: Prentice-Hall. → First published as Le choix des investissements.

Meade, J. E.; and Andrews, P. W. S. 1938 Summary of Replies to Questions on Effects of Interest Rates. Oxford Economic Papers 1:14–31.

Metzler, Lloyd A. (1941) 1965 The Nature and Stability of Inventory Cycles. Pages 100-129 in American Economic Association, Readings in Business Cycles. Homewood, 111.: Irwin. → First published in Volume 23 of the Review of Economic Statistics.

Meyer, John R.; and Kuh, Edwin 1957 The Investment Decision: An Empirical Study. Harvard Economic Studies, Vol. 102. Cambridge, Mass.: Harvard Univ. Press.

Novozhilov, V. V. (1946) 1956 On Choosing Between Investment Projects. International Economic Papers 6:66–87. → First published in Russian.

Robinson, Joan 1956 The Accumulation of Capital. Homewood, 111.: Irwin; London: Macmillan.

Strumilin, S. G. (1946) 1951 The Time Factor in Capital Investment Projects. International Economic Papers 1:160–185. → First published in Russian.

Terborgh, George W. 1949 Dynamic Equipment Policy. New York: McGraw-Hill.

Tinbergen, Jan 1938-1939 Statistical Testing of Business-cycle Theories. 2 vols. Geneva: League of Nations, Economic Intelligence Service. → Volume 1: A Method and Its Application to Investment Activity.Volume 2:Business Cycles in the United States of America: 1919-1932.

Universities-National Bureau Committee for Economic Research 1954 Regularization of Business Investment. Princeton Univ. Press.

II. THE INVESTMENT DECISION

Investment is present sacrifice for future benefit. Investment decisions of economic agents include an individual’s buying a bond, planting a seed, or undertaking a course of training; a firm’s purchasinga machine or constructing a building; and a government agency’sbuilding a dam. Productive investments (such as planting a seed) necessitate a social sacrifice of current consumption and may be distinguished from financial investments (such as purchase of a bond), which reduce to an exchange of titles to consumption between two economic agents.

Normative and positive theories

As in other branches of economics, there are normative (how one should act) and positive (how one does act) theories of the investment decision. In managerial economics and capital–budgeting studies, analysts offer advice as to how private investors should act. The theoretical basis for advice is clearly normative, which is true also of advice offered governments in connection with national or regional planning. The central tradition in investment theory, although also seemingly normative, is positive in aim. The question of how the rational investor should act has been given attention in order to generate testable inferences about how investors do act—or, since the rationality of investors is not essential, to discover the types of investments that will be successful and so will tend to persist (whatever the actual motivation).

Basic concepts

From the point of view of the individual, the investment decision is linked to consumption on the one hand and accumulation of wealth or capital on the other. Consumption in the present and future periods will here be the primitive concept in terms of which the other theoretical terms are defined. Each individual has, at a moment of time, an endowment in the form of a sequence of consumption possibilities or incomes, y_t, in the various periods: y₀, y₁, y₂, • • •, y_t, •••’ Here y₀ is the “current income”—the amount that can be consumed in the present period without adding to or subtracting from the future income elements in the endowment. Investment in any period, i_t, is the amount by which consumption, c_t, falls short of income: i_t = y_t— c_t. By this definition, investment is equivalent to “saving” and maytake on negative values (disinvestment).

Wealth and capital are derivative concepts, referring to time-aggregates of consumption possibilities (incomes). Suppose there is a market in which titles to incomes (“funds”) of various dates are exchanged, as through borrowing and lending. Then one dollar of current funds will exchange for 1 +r dollars of funds dated one year hence, where r is the annual rate of interest (annual compounding assumed). If, for simplicity, it is assumed that the rate of interest is uniform over time, current wealth W₀ may be found by discounting the endowment of incomes according to the formula

With more frequent compounding (at the semi-annual rate ½r, quarterly rate ¼r, etc.), one dollar of current funds would grow to more than l+r dollars in a year. In the limit, compounding may be said to be continuous, and the discounting equation takes on the form

The discrete formulation (1) and the continuous (1’) are both in common use. The amount of wealth reserved for future consumption is denoted capital, K₀, so that the endowment may be subdivided (using the discrete formulation): W₀ = y₀ + K₀.

Irving Fisher’s theory

The modern theory of investment was set down in classical form by Irving Fisher as part of his great work on interest (1930). Fisher looked at investment as a means of achieving an optimal pattern of consumption over time, rather than as a process of accumulation per se. This view permits the extension of the economic theory of choice into the time dimension, the objects of choice being present and future consumption. The elements needed to determine the individual’s investment decision are: (a) the endowment, in the form of an existing income stream over time; (b) the preference function,which orders in desirability all possible time-combinations of consumption; and (c) the opportunity set, which specifies the productive and financial possibilities

for transforming the original endowment into other time-combinations. The theory is fully worked out only under the assumption that economic agents act under certainty or possess complete information; uncertainty will be introduced below.

Figures 1 and 2 illustrate artificially simple cases of investment choice, but cases that are instructive and capable of easy generalization. It is assumed that there are only two periods (say, this year and next); each point in either diagram represents a combination of current consumption, c₀, and future consumption, c₁. The endowment combination, Y, has coordinates (y_o,y₁). The time-preferences are portrayed by the “indifference curves,” U_l, U₂, U₃, • • •, each such curve connecting all combinations yielding equal satisfaction.

In Figure 1 there are financial opportunities only —i.e., exchange opportunities with other individuals that leave wealth unchanged. This isexpressed in the diagram by the ability to move along a “market line,” such as MM’, with slope —(1 +r). To move northwest along a market line is to lend (exchange a dollar of c₀ for 1 +r dollars of c₁); to move southeast is to borrow (give up c_l for c₀). Theline MM’ goes through Y andso defines the triangle OMM’ as the total opportunity set (set of attainable combinations) for the individual with endowment Y. Other market lines, all parallel to MM’, would be appropriate with different endowments. Along each market line, wealth, W₀, is constant. Any addition to current consumption, c₀, by borrowing is balanced by a wealth-equivalent sacrifice of future consumption, c₁ in repaying: W₀=y₁+y_l/(1+_r)=c₀+c₁/(l+r).In Figure 1 the length OM represents W₀. The optimum combination of c₀ and c₁ within the wealth constraint is at M*, where MM’is tangent to the highest attainable indifference curve, U². The amount invested (lent) is y₀–m₀, the repayment being m₁—y₁=(y₀—m₀)(l+r).

In Figure 2 the endowment, Y, and preference function, U₁, U₂, U3, • • •, again appear. But here the curve PP’ through _Y represents productive investment (and disinvestment) opportunities: for example, sowing seed to convert c₀ into c₁. Extensions of productive investments are subject to diminishing returns, shown by the absolutely declining slope of PP’ moving up the curve. If there were only productive opportunities, the relevant opportunity set would be just PP’, and the optimum would be at Q*, where the highest attainable indifference curve touches PP’. Robinson Crusoe, who could engage in transactions with nature but not with a capital funds market, was in such a situation; his amount invested would be y₀ —q₀. But if there are both productive and financial investments (and disinvestments) available, the opportunity set is greatly enlarged to become the triangle bounded by NN’. The optimum is attained in two stages. The “productive solution”, P*, is characterized by the attainment of the highest level of wealth, ̂ W₀. Symbolically,. In a more general n-period case, the productive solution P* is such that

The investor then “finances” the productive solution by moving along the “market hyperplane” of maximum ̂W⁰ through P* to find the best time-distribution of consumption, X*, in terms of his preferences. Thus the capital market permits an increase in productive investment to y₀ — p₀. The increase is made possible by the investor’s ability to replenish current consumption by borrowing (financial dis-investment) in the amount of x₀ — p₀ to attain his optimal time-combination of consumption at X*. Productive investment has increased wealth to⁰W₀=ON; the investor has suffered no diminution of current consumption, although in thecommunity as a whole real saving has takenplace.

This solution is quite general, but there is an interesting special case. We may think of the original two-period example as an illustration of the “widening” of investment, i.e., increasing the level of current sacrifice to attain greater return at some fixed future date. A different two-period problem involves “deepening” of investment. Suppose that the amount of current sacrifice, i₀, is fixed, but the output date is subject to choice (e.g., when to cut a tree). In Figure 3, horizontal distances represent time, t, and vertical distances wealth or value, V, at each moment of time. Present value, V₀, is indicated by height along the vertical axis (where t=0). The curve GG’ represents productive growth of the asset—in the case of a tree, market value of the standing timber. The “discount curves,” D,D’,D”, • • •, are analogous to the “market lines” of figures 1 and 2. They represent the growth of a specific sum of present dollars by continuous compounding of interest over time, so that wealth is constant along a discount curve. Their general equation is V₀=V_te^–rt, where V₀ is the wealth parameter. The optimal investment period ̂t is the one that yields maximum wealth or present value ̂ t₀, a result that follows from the general productive

solution. Here GG’ is the relevant productive opportunity set, and the tangency of GG “with the highest constant-wealth curve attainable corresponds to the productive solution P*. The” financing” decision is not shown in Figure 3, since the preference function cannot be displayed on (t,V) axes, but maximizing wealth is a prerequisite for attaining the over-all optimum.

Decisions of firms and governments

The theory developed above applies strictly to a maximizing individual; the decisions of other economic agents—in particular, business firms and governments—must be considered also. Firms are instrumentalities of individuals for productive purposes only; they cannot consume. Firms have income streams and, therefore, wealth. But all such wealth is held on account, in the form of capital left by owners—ultimately, by individuals—to generate future income. For the firm, the alternative to investment is not consumption, but distribution of current funds back to the owners. Or there may be inflow of funds to the firm from the owners. Decisions that maximize wealth for the firm maximize wealth for the owners.

Government agencies may also be regarded as instrumentalities of individuals. They may engage in essentially consumptive activities of a communal nature—such as national defense. In other respects, governments may act like productive firms, as in the sale of water or in postal service. Government agencies are not “owned” in any simple sense; they may deliberately pursue ends other than wealth-maximization—for example, redistribution of community income. To the extent that satisfaction of such goals is at the expense of the community’s capital, as is ordinary consumption, the goals can be regarded as quasi-consumption objectives. There is, unfortunately, no accepted criterion of social rationality to tell us how far alternative aims should be pursued. Maximizing wealth can be regarded as a partial or limited goal for governments, subject to modification because of competing goals. [SeeBudgeting.]

The criterion controversy

Certain investment criteria employed in business practice, such as rapidity of “payout” (return of capital invested), are obviously erroneous in failing to allow properly for time-discount. Controversy among theorists has centered on the concept variously known as the “internal rate” and the “rate of return” on investment. It is defined implicitly as ρ in the discrete discounting equation

Here the s_t are the successive terms, positive or negative, of the payments-receipts sequence associated incrementally with a particular investment or characterizing an over-all set of investments. In the special “deepening” case illustrated in Figure 3, the corresponding concept under continuous com-pounding is defined implicitly in

Under these conditions p represents an average compounded rate of growth.

The plausibility of maximizing growth has led some analysts to propose, as the investment criterion, adoption of the investment set that maximizes over-all ρ —in contrast to the wealth-maximization criterion of the previous analysis. In terms of the “widening” decision depicted in Figure 2, maximizing ρ would evidently be absurd: both marginal and average ρ on the funds committed are maximized when investment is zero (the highest rate of growth is on the first infinitesimal investment). The proposal has some appeal in the “deepening” choice of Figure 3, where investment, i₀, is held fixed. The solution of (3’) that maximizes ρ is shown as t=B in Figure 3. The Fisher solution, t =̂t, maximizes V₀ (which is equal to V_te^–rt). Which one is correct depends upon the alternatives envisaged. In Figure 3, B is correct if the deepening opportunity can be reproduced (e.g., on new land) on an ever broadening scale, but only as funds are freed (by cutting the tree, in the example). This turns out to be an uninteresting case, as it implies that the opportunity must be of infinite value if ρ>r (and of no value otherwise). Fisher’s solution ̂t is correct if the opportunity is a unique one and cannot be (profitably) reproduced after cutting. Another solution, t=F, found by the German forester Faustmann, is appropriate when the opportunity can be reproduced over time by cutting and replanting but cannot be profitably broadened. F is found by maximizing the V₀ of an infinite sequence of rotations, allowing for cost of replanting; it is a maximum-wealth solution under the stated assumptions. (F is not shown in Figure 3 but would lie between B and ̂t.) Maximizing wealth, within the opportunities available, is the general (productive) solution.

Quite a different “rate of return” rule was proposed by Fisher himself. He argued that it would be equivalent to maximizing present value if every investment project were adopted for which ρ calculated on the associated incremental payments and receipts exceededthe market interest rate, r. (Note that this rule for comparison of ρ and r is not at all the same as maximizing ρ irrespective of r. ) Over a wide class of cases Fisher’s (p,r) comparison rule and his maximum-wealth rule are equivalent. But disparities occur when returns from possible investments are interdependent (options may, for example, be mutually exclusive or, alternatively, complementary); also, in some multiperiod options p is ambiguous or undefined—there may be no solution, or multiple solutions, of the defining equation (3). In all such cases the maximum-wealth rule unambiguously indicates the productive solution, making possible the optimum consumption pattern within the opportunities available.

Recent investigations have explored the implications of more general opportunity sets, productive or financial, than are assumed by Fisher. As was just suggested, investment options in the productive opportunity set may be interconnected in various ways, and indivisibilities may also be important. These complexities of the productive set indicate the need for high-speed computational techniques such as linear and especially integer programming. But so long as perfect capital markets can be assumed, the maximum-wealth rule remains appropriate. The effect of imperfect capital markets is to restrict the financial opportunity set; in the limiting (Crusoe) case, there are no financial opportunities —only productive ones. When the financial opportunities cannot be described by “market lines” like MM’ and NN’, the very concept of wealth becomes ambiguous. Although an optimum can always be obtained, in principle, for any opportunity set and preference function, the great advantage of the wealth concept is that it provides an objective guide to the productive solution, independent of the particular agent’s time-preferences.

Empirical evidence

This economic theory of investment choice is highly abstract and patently neglects some important phenomena bearing on decisions (e.g., uncertainty). Nevertheless, a number of implications drawn from the theory are confirmed by evidence from various realms of experience: (a ) The theory predicts that, other things being equal, an endowment characterized by a rising income stream will encourage borrowing. This is notoriously true, on the individual level, for prospective heirs with “great expectations”; it is also commonly observed in young physicians and lawyers setting up practice. If the rising income stream applies to a region or nation, the pressure of demand for borrowings should lead to high interest. We find that interest has been high, in fact, in the United States during the nineteenth century, in California after the discovery of gold, and in communities struck unexpectedly by earthquake or hurricane—all cases in which future incomes higher than current levels could be anticipated. (b) By a related argument, borrowing demand, and therefore interest, should be high where the productive opportunities are very favorable. California in the 1850s is again a case in point. More recently, U.S. interest rates were higher in the productive decade of the 1950s than in the stagnant 1930s, (c) Divergences in time-preference patterns should also lead to predictable consequences. Fisher credits such groups as the Scots, Dutch, and Jews with a high degree of forethought and concern for posterity, both of which are associated with low time-preference. Interest rates within such groups tend to be low, so that the groups become lenders and investors for the outside world. (d) Although highly productive opportunities lead to high interest, high market interest, other things being equal, is (according to the theory) a deterrent to productive investment. We in fact observe in underdeveloped countries many investment opportunities that are technically more productive than those in advanced countries but that nevertheless go unexploited; high interest is one of the reasons, although there may be others (such as political instability or distance from markets). A clearer case occurs when, within such a country, Europeans and natives engage in the same industry; the former will generally have access to lower-interest finance. Accordingly, it has been observed on the Malay peninsula that peasant small holders tap rubber trees of smaller girth than do operators of European plantations there, (e) The same example illustrates the theoretical implication that an enlarged financial opportunity set, through increased perfection of and wider access to capital markets, leads to an increased scale of investment if there are productive opportunities available.

In recent years, however, some investigations have cast doubt on one implication of the theory: that interest rates and levels of corporate investment, other things being equal, should be inversely associated. Studies using questionnaire techniques have encountered generally negative responses from businessmen on the role of interest rates in influencing investment decisions. And some statistical investigations of investment magnitudes have been unable to isolate the effect of interest—or, indeed, have indicated a perverse result, high interest being associated with high investment.

Currently, econometric investigators tend to discredit the questionnaire technique, on the ground that it elicits the ideas or rationalizations of businessmen rather than information on their actions. It should be noted, however, that even if the questionnaires are correct and only a minority of businessmen respond to interest rates, the over-all effect may yet be significant. The statistical results raise more complex questions. First of all, a lag probably exists between the forces determining investment and statistically measurable construction and equip-ping. Second, the effect of expectations should be allowed for. Theoretically, investment should be inversely associated with interest, if other factors (primarily expectations about investment yield) remain unchanged. But with a change in expectations, upward or downward, investment and interest should move together in response. The more recent studies that have explicitly allowed for lag and for the disturbing effects of changes in expectations have generally shown the anticipated inverse association of interest and investment.

The role of uncertainty

Uncertainty, which may be understood as a subjective condition characterized by imperfect information about the world, influences all economic decisions. But the present may be relatively well known, whereas the future is always risky. Investment choices, involving as they do present sacrifice for future benefit, are peculiarly sensitive to uncertainty. Among the phenomena left unexplained under the certainty assumption are the nonequalization of the yields of various investment media (“assets”) on the market, the mixtures of debt and equity employed in “financing” productive investments, and the value attached to “liquidity.”

An asset is the source of a future, generally uncertain, stream of potential consumption (income). The productive transformations defined earlier correspond to the formation of physical assets. The market transformations correspond to the trading of financial assets (securities) that partition the income stream generated by physical assets. As in the case of certainty, the productive decision under perfect markets aims at maximizing wealth. The consumptive (or financing) decision is much more complex, however; risk-preference is involved as well as time-preference.

The traditional formulation of investment choice under risk—due initially to Fisher (1930) and developed more recently by Markowitz (1959)— postulates that the individual prefers high mathematical expectation but dislikes high variability (as measured, usually, by the standard deviation) of the probability distribution of future income yielded by his portfolio of assets. Making the usual convexity assumption, indifference curves between expected future income, E(c), and standard deviation of future income, σ(c), are represented in Figure 4. For a given level of current sacrifice, the E,cr opportunity set available to an individual by alternative portfolios of risky assets is shown by the shaded area. Because diversification tends to lower

σ, the portfolios along the efficiency frontier FF’ will ordinarily be mixtures of assets. The point A represents a possible portfolio held entirely in a riskless (σ = 0) asset. The “market line” AøZ, tangent at ø to the risky opportunity set, represents (in the range Aø) portfolio mixtures of A and ø made available by the existence of the riskless asset. Depending upon the shape of the preference map, the optimal portfolio M* may be found any-where along Aø —and even along øZ to the extent that riskless borrowing is possible.

Under the assumption that all investors have identical beliefs about the probability distributions, Sharpe (1964) has obtained important results on the properties of optimal portfolios and asset prices. There will in general be a range of perfectly correlated risky portfolios along AZ (rather than the unique optimum at ø shown in Figure 4). In equilibrium there may be defined a “price of risk”— a positive linear relation between the per cent return on an asset and the portion of the asset’s variability correlated with the fluctuations of optimal portfolios. This formulation explains, therefore, both diversification and the divergences of yield among assets. Furthermore, the analysis can be made operational by assuming, for example, that past history can be used as the basis for probability distributions of future returns. In extending this theory of portfolio-choice (governing the media for investment within a wealth constraint) to cover time-choice as well (governing the scale of investment, involving in general productive as well as market transformations), greater degrees of cur-rent sacrifice will be reflected by a rightward shift of the entire opportunity set of Figure 4.

The assumption that preference attaches to the expectation and standard deviation of probability distributions raises a number of analytical and empirical difficulties. However, it turns out that the E,σ formulation can be regarded as an approximation to a formally more satisfactory theory of “time-state-preference” put forward by Arrow (1953). On this latter view, preference attaches not to mathematical properties of probability distributions but to the set of consumption incomes to be received at stated dates and under specified contingencies (states of the world). If, for example, the present is certain but there are two distinct possible future states, a and b, the problem (as a direct generalization of Fisher’s riskless theory) is to attain an optimal balance among c_o (current certain consumption), c_a (future consumption if state a obtains), and c_b (future consumption if state b obtains). Looking only at the balance between the future contingent claims (to isolate the element of risk-preference), aversion to high or corresponds to convex indifference curves on ca, c_b axes. More precisely, it can be shown that, under the von Neumann–Morgenstern postulates of rational choice, riskless solutions (where c_a =c_b or equivalently where σ =0) will be preferred if the prices for the contingent income claims are “fair” (proportionate to the respective probabilities). [SeeDecision Making, article onEconomic Aspects.]

Under the time-state-preference formulation, the individual will seek a productive optimum that maximizes wealth (certainty-equivalent present value). He will then move along his constant-wealth constraint to locate a preferred distribution of claims over times and states. If a firm is investing so as to achieve a wealth maximum, the implication is that (under perfect markets) the specific debt-equity mix chosen to finance the productive solution need not concern the individual owners (their wealth is unaffected). This assertion, which is true only in the absence of external drains (such as corporate income taxes and bankruptcy penalties) on the wealth of the firm, corresponds to a theorem first set forth by Modigliani and Miller (1958).

In the real world, of course, market imperfections (transaction costs) play an important role. In particular, there is reason to believe that there are far too many contingencies to be explicitly traded in markets. Within the limited range of distinct assets that are actually traded, assets represent complex bundles of the contingent dated claims that are the objects of preference. Transaction costs prevent the full attainment of private optimality in risky markets, and explain the desire for “liquidity.”

There are other practical difficulties in applying the maximum-wealth criterion to actual decisions of the firm under uncertainty. It may be far from clear to corporate management, for example, how the market for the firm’s securities would respond to a proposed risky investment. Capital–budgeting analysts commonly recommend calculating the effect of incremental investment on corporate wealth somewhat as follows: First, estimate the investment returns, and then discount to find the present value via equation (1)—using for r the “cost of capital” appropriate for the firm’s “risk-class.” (Alternatively, compare the cost of capital with the p calculated on the estimated returns.) Unfortunately, this sort of “practical” advice leaves both the estimate of returns and the cost of capital rather vague. If perfect markets in time-state contingent claims exist, however, it is possible to define rigorously a “cost of capital” for application to the mathematical expectation of returns in present-value calculations. This cost of capital will be the minimum expected yield, per dollar invested, demanded by the market before funds will be made available for the time-state pattern of returns envisaged. Thus, the proportionate time-state distribution of asset returns is what defines the “risk-class.” Under the E,cr approximation, the risk-class is determined simply by σ (as evaluated by the market). If the market will commit a dollar to an investment with expected return $1.20 (expected 20 per cent yield) and standard deviation $0.50, an investment with the same standard deviation but 30 per cent expected yield would show positive present value (discounting at r = 20 per cent).

It is necessary here to distinguish between the risk-class of the corporation as a whole and the risk-class of a particular incremental investment; the latter is what is relevant for the decision on adoption of the investment. A company whose over-all position was very secure might, by pledging the full credit of the company, finance a risky investment with funds acquired at a low r. But if the expected present value of the investment is only barely positive calculated at this r, the worsening of the company’s over-all risk position will lead to a fall in the market valuation of the company.

Government investment—normative issues. Even if a maximum-wealth criterion is accepted for government investment decisions, serious questions persist as to the interest rate, r, for use in equation (1). To the extent that present-worth or analogous evaluations of investment options have been applied at all, historic practice in the United States has been to use for r the long-term rate on government debt.(In contrast, a somewhat higher rate seems to have been applied for rationing government investments in postwar France.) But private corporations, unless an investment is exceptionally secure, cannot finance at the low rates of debt securities without incurring at least a partially offsetting loss—equity values falling because of increased riskiness. Numerically, federal borrowing rates in the United States in recent decades have been in the 2½–5 per cent range, whereas the average cost (and yield) of corporate capital, counting income-tax liability, has been in the range of 6 per cent to 20 per cent. The inference has been drawn, consequently, that the U.S. government criterion is too lax. Speaking, for simplicity, in terms of (ρ,r) comparisons, use of such a low r has led to the adoption of government investments that are lower-yielding than marginal private investments.

Two lines of argument have been used to combat this inference. The first is that the high rates deterring private investment reflect a socially irrational aversion to variability risk; since government is in a position to pool many options whose average return thus becomes practically secure, a government discount rate lower than the private discount rate is not inefficient. This argument is fallacious; granted the premises, the opposite conclusion follows. Rather than spend on pooled but still low-yielding government projects, it would be more efficient to subsidize the private investments that, in terms of a comparably secure pooled average over the whole private sector, would yield more.

A weightier argument rests on the concept of social time-preference. It is alleged that market interest is too high, biased upward by the time-preferences of the present generation. Since future generations cast no “dollar votes” in current decisions, their concerns are given inadequate consideration in the market. What would be “adequate” consideration requires a social judgment on which opinions differ. (It should be noted that despite the aforesaid bias, almost everywhere in the Western world each generation has in fact sacrificed enough to leave its successor richer than itself.) Adoption of low-yielding investments is, however, an inefficient means of enriching future generations. Much more appropriate would be an increase in aggregate current sacrifice without substituting low-yielding for high-yielding uses of the funds diverted from current consumption. This end could be achieved by a taxation policy penalizing consumption relative to investment.

Finally, governments may, as we have noted, pursue investment objectives inconsistent with wealth-maximization for the community. Government planners may regard investments primarily as levers for altering social structures and attitudes, the rates of growth in specific industrial sectors, domestic distribution of income, or the country’s power and prestige in the eyes of others. In under-developed countries, in particular, governments may control most of the funds available for investment, and goals alternative to wealth-maximization may dominate their planning. In such countries private markets (especially capital markets) are liable to be highly imperfect; even if this were not the case, the government planners may have little comprehension of or tolerance for the working of private market processes. There has been some discussion among theorists about how it might still be formally possible to apply investment efficiency criteria in which planners’ judgments are partially or wholly substituted for market valuations of inputs and outputs and of time-discount. The Soviet system provides an interesting special case. Although explicit interest charges are forbidden on ideological grounds, the practical need to make efficient investment choices has led Soviet economists into discussions of investment criteria that in some ways parallel Western theoretical analyses.

Jack Hirshleifer

[See alsoDecision making,article on Economic aspects; and the biography ofFisher, Irving.]

BIBLIOGRAPHY

THEORETICAL AND EMPIRICAL STUDIES

Arrow, Kenneth J. (1953) 1964 The Role of Securities in the Optimal Allocation of Risk-bearing. Review of Economic Studies 31:91-96. → First published in French in the International Colloquium on Econometrics.

Borch, Karl 1962 Equilibrium in a Reinsurance Market. Econometrica 30:424–444.

Farrar, Donald E. 1962 The Investment Decision Under Uncertainty. Englewood Cliffs, N.J.: Prentice-Hall. Fisher, Irving (1930) 1961The Theory of Interest. New York: Kelley. → The classic work on the investment decision and interest.

Harberger, Arnold C. (editor) 1960 The Demand for Durable Goods. Univ. of Chicago Press; Cambridge Univ. Press. → An empirical study.

Hirshleifer, Jack 1965 Investment Decision Under Uncertainty: Choice-Theoretic Approaches. Quarterly Journal of Economics 79:509–518.

Jorgenson, Dale W. 1965 Anticipations and Investment Behavior. Pages 35–92 in James S. Duesenberry et al., The Brookings Quarterly Econometric Model of the United States. Chicago: Rand McNally.

Lutz, Friedrich A.; and Lutz, Vera C. 1951 The Theory of Investment of the Firm. Princeton Univ. Press.

Markowitz, Harry M. 1959 Portfolio Selection. Cowles Foundation for Research in Economics, Monograph No. 16. New York: Wiley. → A major pioneering work on uncertainty and the investment decision.

MassÉ, Pierre (1959) 1962 Optimal Investment Decisions. Englewood Cliffs, N.J.: Prentice-Hall. → First published as Le choix des investissements.

Meyer, John R.; and Kuh, Edwin 1957 The Investment Decision. Harvard Economic Studies, Vol. 102. Cambridge, Mass.: Harvard Univ. Press. → An empirical study.

Sharpe, William F. 1964 Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. Journal of Finance 19:425–442.

Smith, Vernon L. 1961 Investment and Production. Harvard Economic Studies, Vol. 117. Cambridge, Mass.: Harvard Univ. Press; Oxford Univ. Press.

Stigler, George J. 1963 Capital and Rates of Return in Manufacturing Industries. National Bureau of Economic Research, General Series,No.78. Princeton Univ. Press.

CAPITAL BUDGETING AND CRITERION CONTROVERSY

Bierman, Harold JR.; and Smidt, Seymour 1960 The Capital Budgeting Decision. New York: Macmillan. → A theoretically oriented manual for corporate investment decisions.

Charnes, A.; Cooper, W. W.; and Miller, Merton H. 1959 Application of Linear Programming to Financial Budgeting and the Costing of Funds. Pages 229-255 in Ezra Solomon (editor), The Management of Corporate Capital. Glencoe, 111.: Free Press. → First published in the Journal of Business, January 1959.

Durand, David (1952) 1959 Costs of Debt and Equity Funds for Business: Trends and Problems of Measurement. Pages 91–127 in Ezra Solomon (editor), The Management of Corporate Capital. Glencoe, 111.: Free Press. → First published as a monograph by the National Bureau of Economic Research.

Gaffney, Merrill Mason 1957 Concepts of Financial Maturity of Timber and Other Assets. Agricultural Economics Information Series, No. 62. Raleigh: North Carolina State College.

Grant, Eugene L.; and Ireson, W. Grant (1930) 1960 Principles of Engineering Economy. 4th ed. New York: Ronald. → An excellent guide to investment planning, designed as an economics text for engineers.

Hirshleifer, Jack (1958)1959 On the Theory of Optimal Investment Decision. Pages 205–228 in Ezra Solomon (editor), The Management of Corporate Capital. Glencoe, 111.: Free Press. → First published in the Journal of Political Economy, August 1958.

Lorie, James H.; and Savage, Leonard J. (1955) 1959 Three Problems in Rationing Capital. Pages 56–66 in Ezra Solomon (editor), The Management of Corporate Capital. Glencoe, 111.: Free Press. → First published in the Journal of Business, October 1955.

Modigliani, Franco; and Miller, Merton H. (1958) 1959 The Cost of Capital, Corporation Finance and the Theory of Investment. Pages 150–181 in Ezra Solomon (editor), The Management of Corporate Capital. Glencoe, 111.: Free Press. → First published in the American Economic Review, June 1958.

Pye, Gordon 1966 Present Values for Imperfect Capital Markets. Journal of Business 39:45–51.

Solomon, Ezra (1956)1959 The Arithmetic of Capital–budgeting Decisions. Pages 74–79 in Ezra Solomon (editor), The Management of Corporate Capital. Glencoe, 111.: Free Press. → First published in the Journal of Business, April 1956.

Solomon, Ezra (editor) 1959 The Management of Corporate Capital. University of Chicago Studies in Business, 3d Series. Glencoe, 111.: Free Press. → An excellent collection of important contributions.

Weingartner, H. Martin 1963 Mathematical Programming and the Analysis of Capital Budgeting Problems. Englewood Cliffs, N.J.: Prentice-Hall.

GOVERNMENT INVESTMENT DECISIONS

Chenery, Hollis B. 1953 The Application of Investment Criteria. Quarterly Journal of Economics 67: 76–96.

Eckstein, Otto 1961 A Survey of the Theory of Public Expenditure Criteria. Pages 439–504 in Universities-National Bureau Committee for Economic Research, Public Finances: Needs, Sources, and Utilization. National Bureau of Economic Research, Special Conference Series, No. 12. Princeton Univ. Press.

Hirshleifer, Jack; DE Haven, James C.; and Milliman, Jerome W. 1960 Water Supply: Economics, Technology, and Policy. Univ. of Chicago Press.

Khachaturov, Tigran S. 1958 The Economic Effectiveness of Capital Investments in the Ussr. American Economic Review 48, no. 2:368–384.

Krutilla, John V.; and Eckstein, Otto 1958 Multiple Purpose River Development. Published for Resources for the Future, Inc. Baltimore: Johns Hopkins Press. McKean, Roland N. 1958 Efficiency in Government Through Systems Analysis. New York: Wiley.

Investment

ECONOMIC INVESTMENT

EFFICIENT FINANCIAL MARKETS

SAVINGS AND INVESTMENT

INVESTMENT AND THE BUSINESS CYCLE

TAXATION, REGULATION, AND INVESTMENT

BIBLIOGRAPHY

There are three contexts of investment relevant to the social sciences. First, there is the authoritative investment of endowing a person with social and institutional authority, power, or privilege. Second, a financial investment consists of the production or purchase of an asset in order to obtain its yield, such as interest from bonds. Financial investments involve the exchange of one paper asset (money) for another asset—for example, stocks, bonds, and real estate. Third, an economic investment is the production of some new asset (new plant and equipment, expansion of inventories, new residential construction, reputation) or the creation of new laboring ability (human capital).

The methods of authoritative investing are delegation, inheritance, and usurpation. In a democracy, authoritative investment endows officials with authority in accord with the rules of elections and appointments to office. That authority vests the officials with power and privilege as legally delegated to them from the people, as ultimate sovereignty rests with the people. In a kingdom, royal authority is usually handed down by inheritance, and inheritance also invests heirs with titles to private property. In a dictatorship, the chief of state invests himself or herself with ruling power, and criminals too vest themselves with power over their victims, such as when they illegitimately take property from their victims.

In finance and economics, investing is distinct from speculation. Speculators buy assets with the expectation of gaining due to shifts in supply and demand. Speculators buy shares of stock in a silver mining company if they expect the demand for the metal to increase. Investors buy the stock in order to obtain the dividends from the profits of the firm. The purchase can, of course, include both investment and speculation.

The yields of financial investments include interest, dividends, rentals, capital gains, and business profits. Dividends are a share of corporate profits from stocks or a mutual fund, while interest is obtained from loaned funds, such as bonds and savings accounts. Capital gains occur when an asset sells for a higher price than its initial price of purchase. The return to an investment can also be in the form of the retained earnings or profits of a corporation.

ECONOMIC INVESTMENT

Economic investment consists in the production of capital goods and the enhancement of human capital, the education, skills, and training obtained by workers. A capital good can be intangible, such as when a company invests in advertising in order to create goodwill and reputation capital. Human capital includes relationships with other persons, which is more specifically referred to as social capital. A person also invests in human capital to be a better consumer, such as learning music appreciation to enjoy symphonic music, which is more specifically referred to as cultural capital.

The inputs of production are classified as three “factors,” land, labor, and capital goods. Land means natural resources, existing prior to and apart from human action and its products. The purchase of land is a financial but not an economic investment. Capital goods, such as buildings, machines, and inventory, are products whose value is not yet consumed. Improvements to a site, such as clearing and leveling the surface, are included in capital goods.

A bond is a loan of funds to a borrower who pays interest for the duration or term and returns the funds when the bond matures. The bond might be used by the seller to produce capital goods, but the bonds are not in themselves produced goods and so are not an economic investment.

Technology is embedded in both capital goods and in human capital. If there is no change in technology, investments eventually have diminishing returns. Given a fixed area of land, fertilizer can increase the yield of a crop, but as more and more fertilizer is added, the extra amount of fertilizer provides a reduced amount of extra yield. If one keeps adding fertilizer, eventually the marginal product or extra yield becomes zero and then negative—too many cooks spoil the broth.

An increase in the amount of a variable input eventually yields diminishing returns when some other input is fixed. However, there can initially be increasing returns from more investment if there are network effects that increase the value of each good. For example, if fax machines are more widespread, then a machine has higher usefulness because it can send and receive messages from more units. Capital goods can also complement other investments so that there are at first increasing returns. But such increasing returns themselves eventually diminish. Much of the historic increase in productivity has come not just from an increase in the stock of capital goods but from better technology. There are no diminishing returns to better technology.

Both capital goods and human capital depreciate; they lose economic value due to “wear and tear” as well as from obsolescence and uncertainty. Gross investment is the total amount of production of capital goods and human capital, while net investment equals gross investment minus depreciation. In national income or output accounts, typically only investments in capital goods are included in the investment category in calculating gross and net domestic product.

EFFICIENT FINANCIAL MARKETS

The purpose of investment is to maximize future consumption, thus to obtain the greatest increase in future yields. The optimal investment has the highest risk-adjusted rate of return. Risk means the possibility of loss with a known probability. Uncertainty means the possibility of change with no known probability. The optimal investment has the greatest net present value, the value at present of a stream of future income minus the initial outlay and other costs, discounted by the relevant interest rate.

Even though subject to large fluctuations, financial markets tend to be rather efficient, meaning that the prices of financial assets encompass the known public information about the asset, the relevant industry, and the economy. The seller is pessimistic, believing the price will fall, and the buyer is optimistic, believing the price will rise. The price is the midpoint between the pessimists and the optimists. On the average, one who buys the stock will do no better than the market average. In fact even most professional financial managers and advisers have not performed better than market averages in the long run.

The concept of efficient markets does not imply that prices are perfect reflections of future earnings and economic conditions but rather that it is not likely that one will systematically profit from market timing or stock picking. It does imply, however, that riskier assets will normally have a higher return to compensate for the greater possibility of loss or of the greater fluctuations that make the price at some future date less predictable.

The theory of efficient markets for financial investments is called modern portfolio theory (MPT). It prescribes that an investor should seek no more than to match the averages of the various sectors of financial markets. However, the relevant knowledge has to be utilized by some investors or speculators in order to set the efficient price in the first place. Research into companies, industries, and the economies must offer some reward, and in an efficient market this reward would be commensurate with other gains.

Efficient markets also do not preclude some financial analysts from having insights and analysis superior to those of others in some types of markets and economic conditions. Not only is there great uncertainty about future economic variables, such as inflation and interest rates, but there is also a lack of consensus about many aspects of economic theory, such as business cycles.

SAVINGS AND INVESTMENT

Savings equal income minus consumption. In economics, consumption means the using up of economic value, like fire consuming wood. Production means the creation of economic value. The consumption of a house consists in its depreciation. The purchase of a car has the same economic characteristics; the car is an investment, and its consumption is the depreciation. From the economic point of view, all goods that one buys are investments until they are consumed, although in national income accounts, outlays other than for a house are counted as consumption.

Savings are either invested or kept in money. Few people normally hoard large amounts of cash, so ordinarily people save money in a financial institution, such as a bank or a money market fund. These institutions in turn loan out their money. Money borrowed for consumption offsets some of the money saved, and the rest is spent for investment. Thus in general the net savings of households is either invested or kept as money in the banking system. Banks are legally required to have a small portion of their deposits held in reserve, and they loan out the excess reserves.

Investment comes from savings, but the amounts households plan to save do not necessarily equal the amounts that investors seek to borrow. If investors seek to borrow more than what is available from savings, then the market rate of interest will rise, reducing the amount of intended borrowing while increasing the amount of savings. If the supply of savings increases, then interest rates fall as bankers seek to loan out the excess reserves. The market rate of interest thus has an important role in the economy: it equilibrates savings and investment so that the quantity of loanable funds supplied by savings equals the quantity demanded for investment by borrowers.

The total savings in the economy also includes government savings, government revenues minus government spending. A government deficit that is used for consumption creates negative savings, a reduction in national savings. Government bonds can compete with corporate bonds, raising interest rates and “crowding out” private investment that would have taken place unless the funds are borrowed from abroad or private savings increase. Unless the deficit spending is used for productive investments, such as infrastructure, the government deficit can burden future generations by reducing private investment and also by making future taxpayers pay interest on debt that does not benefit the present generation.

INVESTMENT AND THE BUSINESS CYCLE

Investment fluctuates much more than consumption. Major changes in investment drive the business cycle as recessions occur after a large decline in investment. Investment declines because entrepreneurs expect lower profits, and profits usually decline either because costs have gone up or because the demand for goods is expected to fall. In some economic models, the accelerator principle asserts that investment depends on the annual increase in output and the capital needed to produce the increase. The more fundamental explanation is that savings, interest rates, and expectations about the future determine the amount and the mix of investment.

Lower real interest rates induce more investment in fixed capital goods, such as real estate construction. When the monetary authority expands credit by injecting money into the banking system, the interest rate is lowered as the banks seek to lend out the extra money. Later, to prevent excessive inflation, the monetary authority then reduces the rate of money growth, and interest rates go back up. Investments profitable at the previous lower interest rates are no longer profitable, reducing investment and also wasting capital that would have been better invested in goods with a faster turnover.

Meanwhile the lowered rate of interest also makes it attractive to invest and speculate in real estate. Much of the benefit of economic growth is soaked up by higher rentals and land values due to the fixed supply of land and implicit subsidy to land values from public works not financed from the generated rents.

Speculative demand adds to the demand for use, pulling up real estate prices. At the peak of the boom, higher interest rates plus higher real estate costs diminish profits, and industries such as construction slow down. The diminishing investment reduces demand for other goods, and the economy falls into a recession. Real estate prices and interest rates then fall, and the reduced costs eventually lead entrepreneurs to invest again, and then the economy recovers.

TAXATION, REGULATION, AND INVESTMENT

Income taxes reduce investment by taxing the interest, dividends, profits, and capital gains from savings, enterprise, and investment. The effect is more severe when, as in the United States, the income tax is on nominal gains and nominal depreciation, ignoring inflation, thus taxing the principal as well as the gain. This excess burden has been recognized by providing for tax sheltered savings, such as individual retirement accounts (IRAs), by lower tax rates on capital gains, and by investment credits for businesses. Nevertheless, much of investment remains subject to taxation. Sales and value-added taxes have similar excess burdens. Some economists advocate shifting public revenues to pollution charges, user fees, and rents of natural resources to avoid excess burdens on investment in both capital goods and human capital.

Regulations can enhance markets, such as when they prevent fraud, but they also impose costs similar to taxation. Excessive restrictions and reporting costs can create a deadweight loss similar to taxation, a reduction of investment not offset by social benefits.

SEE ALSO Finance; Macroeconomics

BIBLIOGRAPHY

Elton, Edwin J., Martin Gurber, Stephen Brown, and William Goetzman. 2006. Modern Portfolio Theory and Investment Analysis. 7th ed. Hoboken, NJ: John Wiley.

Haugen, Robert A. 2001. Modern Investment Theory. 5th ed. Upper Saddle River, NJ: Prentice Hall.

Fred Foldvary

INVESTMENTS

There was a time when many individuals thought that investing was for the rich and that very few people could afford to take on the risk that investments appeared to require. But, of course, times have changed; many Americans do invest. They realize that their long-term financial security does not look promising if it is based only on Social Security and company-provided pension plans. Both the numbers of people investing and the types of investments available have increased, especially since the early 1980s. The possibilities for investing funds are far more extensive than just stocks or bonds. In this entry, ten of the most popular investment instruments, from A (annuities) to Z (zero coupon bonds), will be discussed.

ANNUITIES

An annuity provides a means of reducing the risk of outliving one's investment income after retirement from full-time employment. Purchasing an annuity may be a possible solution to reducing this risk. An annuity may be considered the opposite of a traditional life insurance policy. An individual who buys insurance agrees to pay annual premiums to an insurance company. In return, the company will pay, according to instructions agreed upon at the time of purchase, the face value of the policy in a lump sum to beneficiaries when the purchaser dies.

By contrast, an individual who buys an annuity pays the insurance company a sum of money and, in return, will receive a monthly income for as long as the purchaser lives. Naturally, the longer one lives, the more money is received. The holder of an annuity never outlives the return, regardless of how long-lived the individual is. Life insurance protects one's beneficiaries against financial loss as a result of the purchaser's dying too soon, while annuities protect purchasers against financial loss as a result of living longer than their funds do.

Annuity income depends on life expectancy and is thus classified as life insurance. Understanding this is important because the classification allows the annuity's investment earnings to be treated as tax-deferred, with no tax on its accumulation until payments are received.

CERTIFICATE OF DEPOSIT

The concept of the certificate of deposit (CD) is simple. It is a savings instrument issued by a financial institution that pays the purchaser interest at a guaranteed rate for a specific term. When the CD reaches maturity, the investor receives the principal and interest earned. Unlike bond interest (paid periodically), the interest from a CD usually compounds, which means interest is earned on prior interest earned also. An investment in CDs, up to $100,000, is insured by the federal government.

CDs are appealing for safety, liquidity, and convenience. Less appealing is the lower yield when compared with other investments. CDs make sense as emergency funds, savings for short-term goals, a way to complete a long-term goal, and a place to "park" money while an investor seeks more profitable investments.

CORPORATE BONDS

A bond is a form of debt issued by a corporation in exchange for a sum of money lent by the buyer of the bond. The issuer of the bond promises to pay a specific amount of interest at stated intervals for a specific period. At the end of the repayment period (on the maturity date), the issuer repays the amount of money borrowed.

It is important to understand the differences between corporate bondholders and corporate stockholders. The holder of a corporate bond is a creditor of the corporation that issues the bond, not a part owner, as is a stockholder. Therefore, if the corporation's profits increase during the term of the bond, bondholders receive no benefit since the amount of interest they receive is fixed at the time the bond is purchased. On the other hand, the bondholders' investments are safer than those of the stockholders. Interest on bonds is paid out before dividends are distributed to stockholders. Furthermore, the claims of bondholders take precedence over those of the stockholders in the case of bankruptcy or liquidation.

When interest rates rise, bonds lose value; when interest rates fall, bonds become more attractive. Most bonds issued today are "callable," which means corporations can recall them if interest rates rise before the maturity dates.

GOLD

Some investors find gold an appealing investment. Gold has been used as money since biblical times. Several characteristics of gold have made it desirable as a medium of exchange and for investment. Gold is scarce. It is durable. More than 95 percent of all the gold ever mined during the past 5,000 years is still in circulation. It is inherently valuable because of its beauty and its usefulness in industrial and decorative applications.

Gold has been referred to as the "doomsday metal" because of its traditional role as a bulwark against economic, social, and political upheaval and the resulting loss of confidence in other investments, even those guaranteed by national governments.

As an investment, gold is not for the faint of heart or for people who desire a high level of predictability. Its value can fluctuate daily, owing to economic and political conditions. When interest rates in the United States fall, the dollar grows weaker in relation to other currencies. As a result, foreign businesspeople find U.S. investment less attractive, and some of them invest in gold instead. This forces the price of gold higher. When interest rates in the United States rise, the reverse occurs.

Investing in gold may be done in several ways: bullion, coins, shares and funds, and certificates. A number of companies specialize in the buying and selling of gold.

MONEY MARKET ACCOUNTS

Money market fund firms operate by combining many small investors' funds to accumulate the volume of money needed to buy money market instruments. Since the instruments purchased by the fund have differing maturities, the fund earns interest on a daily basis. Each investor receives a statement, usually monthly, of interest earned monthly. The amount earned on an investment varies continually as the current interest rates in the money market rise and fall.

A minimum deposit is required to open a money market account; $1,000 is typical. Additional funds may be added to one's investment at any time, and the funds are completely liquid—one can make withdrawals whenever one wishes.

Another important point about this type of investment: Because of the liquidity of a money market fund, it is an ideal way to invest idle cash that might otherwise find its way into a low-paying passbook savings account. For example, placing the proceeds from the sale of securities into a money market fund until one has decided upon one's next investment venture is a good way of earning continuous interest on one's money.

MUNICIPAL BONDS

Municipal bonds are issued by local and state governments to raise money to provide services and to build schools, roads, water and sewer facilities, and other public works. In order to meet these expenses, communities borrow money from citizens and institutions by issuing debt obligations known as municipal bonds (munis), which are tax-exempt.

Among the more popular varieties of municipal bonds available are the following:

1. General obligation (GO) bonds. These are backed by the full faith and credit of the issuing agency. Interest payments on GO bonds are supported by the taxing authority of the state or city government and are generally considered the safest form of municipal bond.
2. Revenue bonds. These are usually issued by a government agency or commission that has been charged with operating a self-supporting project, such as highway or bridge. The money raised through the sale of revenue bonds goes to finance the project, and the income realized from the completed project (tolls, for example) is used to pay the interest and principal on the bonds.

For the investor, the most important advantage of municipal bonds is that they earn interest income, which is tax-free at the federal level. If investors live in the state in which the bonds are issued, the bonds are usually free from state and local taxes as well. The downside of tax-free munis is high minimum investment requirements, lower yields, and the fact that the issuer can recall them before they mature.

MUTUAL FUNDS

Mutual funds are called mutual because a large number of investors' provided money to form a pool to be managed by knowledgeable investment professionals. The price of a share in the mutual fund is determined by the value of the fund's holdings. As the value of the stocks owned by the fund increases, the share price increases and the investors make a profit: If the value of the stocks decreases, the shares are worth less and investors suffer a loss. The price of a share in a mutual fund (determined by dividing the net value of the fund's assets by the number of shares outstanding) is usually announced once or twice a day. A mutual fund also earns dividends that may be paid directly to investors or reinvested to buy additional shares in the fund.

Therefore, mutual funds can make money for their investors in three distinct ways:

1. The shareholders receive dividends earned through the investment that the fund possesses.
2. If a security in the fund's portfolio is sold at a profit, a capital gains distribution will be made by the fund to its shareholders.
3. If the value of the fund's portfolio increases, the value of each share also increases.

Mutual funds offer an easy way to diversify money, control risk, and benefit from professional money management at a reasonable cost.

SAVINGS BONDS

The EE bond is a nonnegotiable security against the credit of the U.S. Treasury—nonnegotiable because once it is purchased, it cannot be resold to anyone else, but may be sold back only to the government at a fixed price. The bonds may, however, be transferred to someone else.

Series EE bonds are sold at half their face value and are available in denominations of $50, $100, $200, $500, $1,000, $5,000, and $10,000. Thus savings bonds are available for as little as $25, making them a practical choice for the investor with only a minimal amount of money to set aside. It is possible to purchase EE bonds online at TreasuryDirect (http://www.savingsbonds.gov)—a government Web site that is run by the Bureau of the Public Debt, part of the U.S. Department of the Treasury—where the amount invested and what is paid differs from the paper EE bond just described.

Another type of savings bond is the I bond; it is sold at face value and will grow with inflation-indexed earnings for up to thirty years. The I bond can also be purchased online at TreasuryDirect.

There are advantages that both of these bonds possess:

• Competitive: Their rates of return are generally comparable to other forms of savings and accrue interest monthly and compound semiannually.
• Safe: They are backed by the full faith of the United States and are registered, which is helpful if bonds are lost, stolen or mutilated.
• Convenient: Bonds may be purchased at banks, online at TreasuryDirect, or where one works, if one's employer has such a deduction plan.
• Accessible: They are easily redeemable after six months.
• Tax benefits: The interest earned on savings bonds is exempt from all state and local income tax and is deferred for federal income tax until sale or maturity.

TREASURIES

Treasuries refers to a range of U.S. Treasury obligations. In a low-interest economy, many people switch to investments with higher yields, getting away from their traditional CDs. A safe and secure short-term investment that is an alternative for the CD is the Treasury bill (T-bill). Longer-term notes and bonds are also available.

Treasury obligations are tax-exempt at the state and local levels and are backed by "the full faith and credit" of the United States. The credit risk involved in this form of investment is considered practically nil. In comparison with similar obligations issued by corporations, Treasury obligations usually pay a yield, which is one or two percentage points lower. Many people, however, are willing to accept the slightly lower yield in exchange for the high level of safety.

There are four types of issues of Treasuries, which each require a minimum investment of $1,000. These are tax-free at state and local levels and can be bought through a broker, bank, or the Treasury. The T-bill is a thirteen or twenty-six-week instrument that is issued at a discount but pays face value at maturity. Treasury notes earn and pay a fixed rate of interest every six months and are issued in terms of two, three, five, and ten years. Treasury bonds are sold at thirty-year maturities and pay interest every six months. A fourth hybrid bond is a Treasury inflation-protected security, which provides protection against inflation based on the Consumer Price Index and is sold in terms of five, ten, and twenty years.

ZERO COUPON BONDS

Is there an instrument that lets an investor know exactly how much money will be available at a particular future date (whether it be for the education of one's child, retirement, etc.) and, if administered correctly, becomes tax deferred or even tax-exempt? Yes, the zero coupon bond meets these expectations.

Zero coupon bonds have some advantages over other types of long-term investments. They have become an excellent choice for individual retirement accounts, 401(k) plans, Keogh plans, and other pension funds, and most certainly for a child's college savings. They are therefore an ideal investment for investors who are more concerned about "outcome" rather than "income."

Bonds are debt obligations issued by a corporation or by a federal, state, or local government agency. When one buys a bond (usually at face value), one is buying a promise from the issuing institution to pay the amount of the face value of the bond at maturity.

Zero coupon bonds are sold at a price well below face value. Thus, these bonds are appealing to the small investor because they can be bought far more cheaply than ordinary debt obligations. The discount is usually from 50 to 75 percent.

SUMMARY

The variety of investments available provides varying advantages and disadvantages. A careful study of the different types in consideration of goals for investment and level of risk to be accepted is worthwhile. Such study provides the investor the basis for making decisions about the extent and nature of variability wanted in one's personal portfolio.

see also Bonds; Financial Literacy; Mutual Funds; Stocks

bibliography

Graham, B., and Zweig, J. (2003). The intelligent investor. New York: HarperCollins.

Kiplinger's practical guide to your money (3rd ed.). (2005). Chicago: Dearborn.

Lange, J. (2006). Retire secure. Winchester, VA: Oakhill Press.

Tyson, Eric (2005). Investment for dummies (4th ed.). New York: Wiley.

Joel Lerner

Investment

What It Means

In economics the term investment refers to purchases that contribute to the overall performance of an economy. This form of investment occurs in all sectors of society and usually involves the participation of individuals, businesses, and governments. When the overall level of investment is high, an economy generally expands, creating greater prosperity for a wider range of the population. When investment is low, the economy generally falters. As such, fluctuations in investment are the primary drivers of the business cycle—the repeated pattern of growth and slowdown that exists in all market economies.

In most cases investment refers to money spent on durable goods. Durable goods are generally defined as products that are designed to be used repeatedly over a relatively long period of time; according to most economists, a product is considered a durable good if it lasts three years or more. For most people durable goods refer to such material items as television sets, cars, and homes; by purchasing these goods, individuals contribute to the prosperity of the businesses that manufacture the goods, thereby bolstering the economy. Companies typically invest in such durable goods as manufacturing equipment and machinery, while governments invest in infrastructure such as roads, bridges, and dams. The products purchased through this form of investment are often referred to as tangible, or material, assets. Investment can also refer to spending on intangible, or nonmaterial, assets. Intangible assets can include education, skilled labor, or research.

People invest for a variety of reasons. Individuals can invest money in homes in order to improve their quality of life, or they can invest in higher education in order to increase their chances of finding a high-paying job. In both these cases, investment contributes to the overall health of the economy, both through the purchase of durable goods and the potential improvement of the workforce. This type of investment is also known as residential investment. A business will invest in new technologies in order to increase the efficiency of its production process. Government investments in infrastructure contribute to the economy by making it less costly for companies to transport goods. In a sense, all of these various forms of investment work together within an economy, generating economic opportunity, low-priced goods and services, and greater wealth.

When Did It Begin

In certain respects investment has existed since the earliest human civilizations, as ancient societies devoted a portion of their resources to producing and selling goods, building roads and fortifications, and generally contributing to the economic health of the community. Investment in the modern sense, however, did not play a significant role in the economy until the Protestant Reformation of the sixteenth century. According to German sociologist Max Weber (1864-1920), the people who held power in ancient Greece and Rome derived their wealth from land ownership and slave labor. These elite viewed commercial transactions, and working in general, as undignified; at the same time, they feared that large-scale investment would only create a broader base of wealth among the general population, thereby eroding their own power. With the Reformation, however, a new attitude toward commercial activity arose, one based on ideals of hard work (which Weber called the Protestant work ethic), individualism, and economic growth. In order to meet these goals, new business strategies, including investment, began to gain wider acceptance. Weber argued that the emergence of investment as a means of spurring economic expansion represented one of the key factors in the birth of modern capitalism.

The industrial revolutions of the late eighteenth and early nineteenth centuries witnessed an explosion of investment in both England and the United States, as new technologies accelerated the speed at which goods could be produced. Increased production levels resulted in significantly higher earnings, which led to increased financial investment in commercial activities. Indeed, the entire history of American economic expansion is rooted in the principle of investing in cheaper, more efficient ways of manufacturing goods and services.

More Detailed Information

When businesses consider how to invest their money, they focus on the potential benefits that might result from their investment. Since the goal of all profit-based companies is to earn money, business investments are made with the aim of increasing, or at least maintaining, profit levels. Companies achieve these goals by investing in new machinery, hiring more workers, and funding other expenditures designed to increase their capacity to create more products.

Businesses generally employ two means of funding their investments. In many cases a company will use profits from its existing operations, either to reinvest in its core business (for example, manufacturing tires) or to invest in the creation of a new form of business (such as introducing a line of windshield wipers). A company will also borrow money (a business loan or a line of credit) in order to invest in the expansion of its core operations. Ideally the money earned from the increase in production capacity will be greater than the money invested, thereby earning the company a profit. For example, say a tire manufacturer earns a profit of $200,000 in a given year. The company may want to invest that money in building a second factory, with the ultimate aim of doubling its manufacturing capabilities. If the cost of building a new factory is $1 million, then the company may use its profits for some of the expenditures (buying new equipment or hiring new workers) while taking out a loan to pay the remaining expenses. Once the second factory becomes operational, it will begin to generate income. For the first year or two, the earnings from the second factory might not offset the costs involved with getting it started, and the company may use all its earnings from that period to pay off its debt. By the third year, however, the company may have paid down its debt considerably and begun earning substantially higher profits than it did before building the second factory.

Government investment also plays an important role in the economic prosperity of private businesses. Government construction projects require the hiring of private businesses, thereby stimulating economic activity. When government invests money in infrastructure, a nation’s commercial activities also tend to run more smoothly: good roads and bridges help save transportation time while also reducing wear-and-tear on shipping vehicles, and power stations provide massive amounts of energy to companies throughout the country, enabling them to operate at a high capacity. When government investment in infrastructure declines, as it did during the 1980s, private industry will usually feel the effects.

How money is invested from year to year generally reflects broader trends in politics, the economy, and technology. During periods of increased economic expansion, people invest in commercial activities at a much higher rate, which in turns fuels continued growth. Eventually, however, the economy will inevitably slow down, and investment rates will fall. In this sense investment is regarded by economists to be a cyclical phenomenon.

Recent Trends

Because of the inherently volatile nature of economic activity, investment typically fluctuates over time. A comparison of investment trends in the United States during the 1990s and the early 2000s offers a valuable illustration of how patterns of investing can vary widely. Between 1995 and 2000, business investment in the U.S. rose at a rate of 10 percent per year. In the second half of 2000, however, this trend reversed itself dramatically, as investment dropped nearly 12 percent. Economists attribute this decline to the infamous “dot-com” bust, during which hundreds of computer and information technology firms declared bankruptcy. As a result of this decline in investment, by March 2001 the country had entered into a recession (a period of economic contraction).

INVESTMENT

Investment refers to the acquisition of an asset for the sole purpose of producing future monetary income and/or capital gains. For an individual an investment may consist of the purchase of financial assets such as stocks, bonds, life insurance, and mutual funds, or physical assets such as a house or a car. Economists define investment as the increase in capital goods in an economy. Capital goods are the material or human resources that enable a business to produce a product or service. Investments in capital goods by businesses would include the purchase of factories, buildings, machinery, or a skilled and knowledgeable labor force. Businesses may also invest in research and development projects in order to improve their products or create new ones. For a business a successful investment is considered to be one that increases profits that can be passed on to shareholders which, in turn, raises the value of a company's stock.

A business's decision to invest in a particular item or project is based on two considerations. The first consideration is the expected rate of return on the investment, or how much profit the investment will generate for the business. The expected rate of return can be estimated based on forecasts of potential sales, profits, and expenses. The second consideration is how much risk is involved in obtaining the expected rate of return. Whether an individual or a business makes an investment, evaluation of risk is essential to successful investing. Practically every investment has some capacity for financial loss, but the degree of risk involved can vary greatly. Therefore investors need to estimate how much loss can feasibly be assumed and limit any risks accordingly.

See also: Capital Goods, Profit, Speculation, Stock