Module 3 Savings and Investment PDF

MODULE 3 SAVINGS AND INVESTMENT Unit 1 Savings and Investment Unit 2 Negotiable Instruments Unit 3 Clearing Banks UNIT 1 SAVINGS AND INVESTMENT CONTENTS 1.0 Introduction 2.0 Objectives 3.0 Main content 3.1 The concept of savin...

MODULE 3 SAVINGS AND INVESTMENT Unit 1 Savings and Investment Unit 2 Negotiable Instruments Unit 3 Clearing Banks UNIT 1 SAVINGS AND INVESTMENT CONTENTS 1.0 Introduction 2.0 Objectives 3.0 Main content 3.1 The concept of savings 3.2 The Concept of Investment 3.2.1 Meaning of Investment 3.2.2 Types of Investment 3.2.3 Forms of Investment 3.2.4 Theories of Investment 3.2.5 Determinants of Investment 3.3 The Relationship between Savings and Investment 3.4 The Paradox of Thrift 3.5 The ISLM Framework 4.0 Summary 5.0 Conclusion 6.0 Tutor-marked Assignment 7.0 References/ further Reading 1.0 INTRODUCTION The economy is a complex web if activities, but by and large it hovers around the productive and monetary sectors. The monetary sector is anchored by the banking sector which in turn drives the entire economic process. However, in the long run, it is asserted that at equilibrium savings must equal investment. 2.0 OBJECTIVES At the end of this unit, the student will determine the following:  Meaning and types of Investments  Theories and determinants of Investments 3.1 THE CONCEPT OF SAVINGS Savings is defined as the difference between disposable income and consumption. In terms of economic units use of savings, refers to that portion of disposable income which is not finally consumed but somewhat reserved for future use. National Income is actually the totally of what is rewarded to the economic units for effort put in place to generate wealth. It is depicted thus: Y = C + S + I + G + (x-m) Hence: Yd = Y-T Yd = C + S S = Yd - C Y = C + S + I + G + (x-m) Where: Y = National income C = Consumption S = Savings T = Tax Yd. = Disposable Income The level of savings depends on the level of income, all things being equall. As income increases the potential for savings also increases, but by less than proportionately. The relationship between income and saving is therefore referred to as the propensity to save or savings function which can be represented as : S = F(Y) The above stated equation shows that saving is a function of income (Y), while S is the dependent variable, Y is the independent variable. The relationship is hung on the “ceteris paribus” (i.e. all things being equal) assumption which indicates that every other factor that could affect saving are held constant. This relationship can be further explained using this table: Income Consumption Savings Aps Mps (y) (c) (s) (s/y) (∆s/∆y) 0 20 -20 - - 30 40 -10 -0.33 - 60 60 0 0 0.33 90 80 10 0.11 0.33 120 100 20 0.17 0.33 The above table shows that when income is zero people do not save but still spend on consumption and when income equals consumption savings become zero (0), but as income rises consumption also tend to rise and so does saving. The relationship that exists between savings and income i.e. propensity to save is of 2 types: 1. Average Propensity to Save (APS) This is an important relationship between income and savings, it is the proportion of disposable income that is saved. It is mathematically represented as; APS = Savings = S Disposable Income Y APS relates total savings to income 2. Marginal Propensity to Save (MPS) This measures how much of the additional disposable income is saved i.e not consumed. It is a ratio of the change in savings to the ∆ in income. MPS = ∆S ∆Y It relates changes in savings to changes in income Meaning of Investment In ordinary parlance, is the sacrifice of certain economic resources for future uncertain benefits in terms of resources as well. It also means to buy stock, shares, bonds and securities which are already existing in the stock market. But that is not real investment because it is simply a transfer of existing asset and as such does not determine income and employment. Investment in this context refers to addition to the stock of physical capital. It refers to expenditure spent on the acquisition of capital goods. Basically, investment in this text refers to the purchase of real tangible assets such as machines, factories or stock of inventory which are used in the production of goods and services for future use as opposed to present consumption. 3.2.2 Types of Investment 1. Fixed Investment: This is the purchase of new fixed capital such as machines, tools etc. 2. Inventory Investment: This is investment in building stocks of goods and raw materials. 3. Replacement Investment: These are investments made to replace worn-out capital goods resulting from their use in the production process. 3.2.3 Forms of Investment Two forms of investment has been identified by Keynes; 1. Autonomous Investment 2. Induced Investment Autonomous Investment: is a form of investment that does not change with the changes in the income level and as such is independent of income.Autonomous investment is mostly undertaken by government and it includes projects such as power, transport and communication. Autonomous investment is affected more by population growth and technical progress than income level.It is income inelastic. In the above graph it is obvious that level of investment is constant irrespective of change in natural income. Induced investment: as the name implies is induced, influenced or affected by changes in income level. If income level increases, consumption demand would also increase and to meet up, investment must increase. Factors such as wages, work force and interest change affect people and induced investment. This induced investment can further be broken into: 1. Average propensity to Invest: the rate of investment to income It can be mathematically represented as: I Y 2. Marginal Propensity to Invest: this is the ratio of changes in investment to changes in income. It can be mathematically represented as: ∆I ∆Y It is obvious in the above graph that changes in the level of national income causes a change in investment level. 3.2.4 Theories of Investment The Acceleration Theory of Investment; According to this theory, “when income or consumption increases, investment will increase by a multiple amount”. When income and therefore consumption of the people increases, the greater amount of the commodities will have to be produced. Since in this case, investment is induced by changes in income or consumption, this is known as induced investment. The acceleration is the numerical value of the relation between the increases in investment resulting from an increase in income. The net induced investment will be positive if national income increases and induced investment may fall to zero if the national income or output remains constant. To produce a given amount of output, it requires a certain amount of capital. If Yt output is required to be produced and V is capital-output ratio, the required amount of capital to produce Yt output will be given by the following equation: KE = V*Yt Where K = Stock of Capital Yt = Level of Output or Income V = Capital output Ratio ( magnitude of acceleration) The capital-output ratio V is equal to K/Y and in the theory of acceleration this capital-output ration is assumed to be constant. Therefore, under the assumption of constant capital-output ratio, changes in output are made possible by changes in the stock of capital. Thus, when income is Yt then required stock of capital KE = v*Yt, when output or income is equal to Yt-1, then required stock of capital will be KE-1 = vYt -1. It is clear from the above that when income from Yt-1 in period t-1 to Yt in period, t, then the stock of capital will increase from Kt-1 to Kt. As seen above, Kt-1 is equal to vYt-1 and Kt is equal to vYt. Hence, the increase in stock of capital in period t is given by the following equation: Kt-Kt-1 = vYt-vYt-1 Since the increase in the stock of capital in a year (Kt-Kt-1) represents investment in that year, the above equation can be written as: It1 = v(Yt-Yt-1) The above equation reveals that as a result of increase in income in any year t from a previous year t-1, increase in investment will be v times more than the increase in income. Hence, it is v i.e capital output ratio which represents the magnitude of the acceleration. If the capital – output ratio is equal to 3, then as a result of a certain increase in income, investment will measure three times more i.e. acceleration will be equal to 3. It thus follows that investment is a function of change in income. If income or output increases over time, that is when Yt is greater than Yt-1 then investment will be positive. If income declines, that is, Yt is less Yt-1 then disinvestment will take place. And if the income remains constant, that is, Yt = Yt-1 the investment will be equal to zero. 3.2.5 Determinants of Investment Investment generally are undertaken because of the expected future return i.e whether the returns expected would or would not exceed the amount invested today. For an investment to be made there are various factors that must considered; 1. Cost of capital asset 2. Expected rate of return 3. Market rate of interest Keynes summed up these factors in his concept of Marginal Efficiency of Capital (MEC). Marginal Efficiency of Capital This refers to the highest rate of return expected from an additional unit of a capital asset over its cost. It is the rate of profit expected from an extra unit of a capital asset. In the words of Kurihara, “it is the ratio between the prospective yields of additional capital goods and their supply prices”. Assume that the supply price of a capital asset is N50,000 and its annual yield is N5000 the marginal efficiency of the asset is; 5000 *100 = 10% 50,000 1 As such the MEC is the percentage of profit expected from a given investment [on a capital assets. Keynes defined the marginal efficiency of capital in the following word: “I define the marginal efficiency of capital as being equal to the rate of discount which would make the present value of the series of annuities given by the return expected from the capital asset during its life just equal to its supply price”. The MEC can be obtained using C = R1 + R2___+ R3__+ ……. +Rn__ 1+r (1+r)2 (1+r)3 (1+r)n Where; C = supply price or replacement cost R1,R2,Rn = annual prospective yield from capital asset r = expected rate of profit Marginal Efficiency of Investment (MEI) The marginal efficiency of investment is the rate of return expected from a given investment on a capital asset after covering all its costs, except the rate of interest. Like the MEC, it is the rate which equates the supply price of a capital asset to its prospective yield. The investment on an asset will be made depending upon the interest rate involve in getting funds from the market. If the rate of interest is high, investment is at a low level. A low rate of interest leads to an increase in investment. Thus, the MEI relates investments to the rate of interest. The MEI schedule shows the amount of investment demanded at various rates of interest. That is why it is also called the investment demand schedule or curve which has a negative slope. The Present Value Criterion of Investment The PV criterion is considered to be the best method for evaluating capital investment proposals. The method is used to evaluate the profitability of an investment project. The Net Present Value is the different between total present value of cash outflows and total present value of cash inflows occurring in periods over the entire life of the project. When the NPV is positive, the investment proposal is profitable and worth selecting. But if it is negative, the investment proposal is non profitable. To calculate profitability index of different investment proposals the following method can be used. PI = Total Present Value of all Cash Flows or Net present value Initial Investment. NPV method considers time value of money, it compares the value of cash flows. NPV = A1 + A2___+ A3__+ ……. + An__ -C 1 (1+r) (1+r)2 (1+r)3 (1+r)n Where: A1,A2,An = cash inflows n = expected life of investment r = rate of discount C = present value of cost Decision criterion for NPV a. If NPV > O project is profitable NPV < O project will not be profitable NPV = O project may or may not be started. If decision is to be taken between two (2) investments, the one with a higher positive NPV would be selected. 3.3 The Relationship between Savings and Investment The relationship between savings and investment has caused series of controversies over the year. While some argue that savings and investment are equal whether at equilibrium or disequilibrium other argue that savings and invest are equal only at equilibrium. Pre-Keynesian economists argue that saving and investment are not equal for certain reasons which include: 1. Saving and investment are made by two different classes of people, i.e. while investment is undertaken by entrepreneurs savings is done by the general public. 2. Savings and investment depend upon different factors and are made for different purposes and motives. 3. They also pointed out that the excess of investment over saving has led banks to create new credit. In spite of the above stated conditions, Keynes in his book, “General Theory of Employment, Interest and Money” showed that investment and savings are always equal. Keynes proved or expressed his assertion about the equality of savings and investment with the following equation: National Income = Consumption + Investment  i.e Y = C+I The above equation represents the production or income side of the national income, and the equation below represents the expenditure side; National Income = Consumption + Savings i.e Y = C+S From the above equators it is clear that national income is equal to the sum of consumption and investment and also equal to the sum of consumption and savings; Hence; C+S = C+I Which in turn is equal to S = I Savings = Investment 3.4 The Paradox of Thrift This concept was first introduced by Bernard Mandeville in the fable of Bees in 1214.Thriftiness is often seen as a virtue, this is because an increase in thrift on the part of an individual leads to greater savings and wealth. The same thrift an also be seen as a public virtue because if people consume less thereby increasing their savings, then more resources can be devoted to producing capital goods which leads to increase in income, output and employment. According to Keynes, thrift is a public virtue if the increase in the propensity to save is responded by an equally high propensity to invest, otherwise it becomes a public vice. The paradox of thrift is basically pointing out that if people decide to save more, they may end up saving less, unless if the increase in propensity to save is accompanied by a higher propensity to invest. So, saving is a virtue for a person or family because it leads to increase in savings and wealth. But it is a vice for the entire society because it leads to reduction in outputs income and employment. Thus, the paradox of thrift leads to the conclusion that saving is a private virtue and a public vice. 3.5 The ISLM Framework The ISLM framework which is shorthand for the equality of investment and savings (IS) which represents the product market equilibrium and the LM which represents the equality of money demand and money supply ( money market equilibrium). Therefore, it is possible to say that the ISML framework is a model that shows the relationship between investment and saving i.e product market equilibrium as it relates to the money market equilibrium. Deriving the IS Curve * Income. * Income The ISLM model explain how interest rates and total output produced in the economy (aggregate output or, equivalently, aggregate income) Income are determined given a fixed price level.The saving curve shows that savings increases as income increases, and investment is dependent on the rate of interest and income level. The level of investment rises with the level of income. At a 6% interest rate, investment curve is 12; if the rate is reduced to 5%, investment curve will shift to 13. At the point 13 investments is more at every level of income, each point on the 1s curve represents a level of income at which saving equals investment at various interest rates. If the interest rate is 7%, the S curve intersects I.curve at E1 in graph (1) and that determines Y1. Now Y1 is on curve level N300 and is matched for intersect the 7% rate at point A in graph (2). When the interest ratio is 6%, the S curve intersects I curve at E2 in graph (1) and that determines Y2, since Y2 (income level) is N400 and is matched to intersect 6% ratio at point B on graph (2). At point C the 5% interest ratio is match to Y3 (income level) of N500. When point A,B and C on graph (2) are linked the IS curve is created, and it slopes downward from left to right because as interest rates fall, investment increase and so does income and saving. The LM curve shows all combinations of interest rates and levels of income at which the demand for and supply of money are equal. The LM curve is derived from the Keynesian formulation of liquidity preferences schedules of supply of money. A family of liquidity preference curve L1Y1, L2Y2 and L3Y3 is drawn at income levels of N200, N300, N400 respectively in graph (1) above. Those curves together with the perfectly inelastic money supply curve gives us the LM curve. The LM relates different income levels to various interest rate. The ISLM Curve This is a combination of the IS and LM curve in one chart. For the product and money market to be at equilibrium IS and LM curves will intersect and the point of intersection is the equilibrium point where the ISML curve is formed. Assume that an economy is at point P, i.e. on the IS curve, though at point P the product market is at equilibrium so that aggregate input equals demand, the rate of interest is above the equilibrium level, and as such the demand for money is less than the supply. If the economy is on the LM curve at point N, it will also head toward equilibrium (E). At point N, although money demanded is at equilibrium with money supply, output is higher than equilibrium and exceeds aggregate demand. This makes it difficult for firms to sell their output, leading them to cut production and lower output. The reduction in output means that money demanded will fall and interest rates will as well fall, this slides the economy down along the LM curve unit it reaches equilibrium (E). 4.0 Summary : The economy makes impact when the finance sector drives the real sector. Thus income being a function of production concerns consumption, investment, savings, government expenditure and export minus import. In a nutshell, disposable income is what is left for consumption and or savings. However at the beginning there is always autonomous consumption income or not. In the long run what is saved becomes what is transformed to investment and at equilibrium investment must equal savings and which is concern with the product market equalizing at the money market-LM. 6.0. Tutor- marked Assignment o Is savings equal to invest? Why? o What do you understand by the paradox of thrift? o what is your understanding of Average propensity to save? Marginal propensity to save? o Differentiate autonomous investment from induced investment. 7.0 References: Ekezie, E. S. ( 1997). The Elements of Banking, Money, Financial Institutions and Markets.Onitsha: AFRICAN-FEP Publishers..Jhiagan, M. L. (2010). Macro Economic Theory, New Delhi: Mishkin. F.S. (1992). The Economics of Money, Banking and Financial Markets, New York:HarperCollins Publishers. UNIT 2 NEGOTIABLE INSTRUMENT CONTENT 1.0 Introduction 2.0 Objectives 3.0 Main Content