Distinguish between the return on investment and the return on capital. Show the respective relevance of each to investment decisions - Essay Example

Macro and micro economics [Insert al Affiliation] An optimal flow of investment and optimal stock of capital From the economic perspective, an optimal flow of investment is the maximum value of cash flows a given investment can yield pursuant to cash flow multiplier of optimal investment policy. Conversely, an optimal stock of capital is the optimum firm’s amount of capital that is represented by the value of issued preferred and common stock i.e. preference shares and ordinary shares.
Keynes’s conflation of investment being a mere homogeneous component of aggregate demand
According to macroeconomics, the aggregate demand is defined as being a total demand for services and goods that are final in an economy at some point in time. Although the effect of the aggregate demand curve is the same as the demand curve, it shows the amount that the government and businesses are willing to spend on good (Perelman, 2007). Keynes postulates that the capital investment in equipment, plant and machinery will increase the production of goods in an economy.
He further, says that investment consists of spending on stocks and finished goods. An increase in interest rate results to a decrease in investment hence a consequent decrease in the total demand. This happens on the ground that the interest rate and investment have an inverse relationship. The increase in interest rate increases the cost of capital hence decrease in demand total. However, a reduction in interest rate will lower the cost of the capital hence increase in investment and a consequent increase in aggregate investment.
Keynes conflation of investment being a mere heterogeneous component of capital
Keynes postulates that aggregate demand has a number of components. The demand function is Y=C(Y-T)+I (r) +G+NX (e) where I is income, I is consumption being a function of disposable income, I is investment being a function of interest rate, G is government expenditure and NX is net exports (exports minus imports).
Keynes further ascertained that investment cannot, therefore, be a sole determinant of the aggregate demand. This means that a change in investment leads to a less proportionate change in the aggregate demand.
V = c [1- (1 + r) n]/r ... rising flow of investment raises the cost of capital and final goods
A rising flow of investment increases the money supply in the economy. The government using its monetary policy, it employs the increase in interest rates to decrease the nominal supply in the economy as it increases the cost of capital (V). Additionally, the increase in the flow of investment increases the money supply in the economy leading to a shift of the money supply upwards and leftwards. This would consequently lead to an increase in prices and the real output (oil, petrol and diesel)
References
Perelman, M. (2007). Keynes, investment theory, and the economic slowdown: The role of replacement investment and q-ratios. New York: St. Martins Press. Read More