“An investment is defined as any asset into which funds can be placed with the expectation that the invested capital will generate additional positive income; and many investors, will insist that, as a minimum requirement, the investment will preserve its value.”1
Investment decisions are often made upon expectations of the future. A well-organised, efficient business will not invest in certain factors of production if the likely return is less than the cost of doing so. Hence, if an individual feels that in the near future or over a longer period, returns from investment outweigh the associated benefits of using income and wealth for consumption purposes then this expectation of the future will entice the individual to invest. It is not a simple matter of looking at an investment and saying 'Yes that looks profitable' and going ahead. Most individuals will have a choice of a range of investment decisions and they need to have a basis for comparing them to evaluate which is the best. A part of this evaluation has to be based on a financial assessment of the projects ('qualitative factors') and partly also on non-financial factors ('qualitative decisions'). Once again, in the financial sense, an investment must be profitable and more worthwhile than if the money was used for consumption and, furthermore, it should earn an expected rate of return that is well above the safe interest rate to allow for risk. As regards to expectations of interest rates, if it looks likely that in the near future the rate will experience a sufficient decline then it could tempt the individual to allocate a greater amount towards investment as opposed to consumption. For example, the individual will be able to borrow a set amount and the value which is required to be paid back will be less if the interest rate is low than if it is high, thus making an investment more cost effective.
The life cycle hypothesis gives a greater understanding of the impact expectations of the future can have upon consumption and investment decisions made by individuals. The idea put forward by Franco Modigliani in 1957 is that different stages in an individual’s life cycle can impact the amount contributed towards consumption and investment. It states that consumers try to average consumption over their lives and, thus, planned consumption is relatively constant whilst income is constant. If there is an increase in income then the MPC will tend to rise but this is only a generalisation as expectations of the future have the most sufficient impact. Age is of importance. It states that the young and the old tend to be more positive towards consumption, whilst the middle-aged have a tendency to be more careful in their spending habits and, therefore, allow a greater percentage of income and wealth to be used as investment.
The permanent income hypothesis is also of relevance. It suggests that people have adaptive expectations, whereby they form their level of expected future income based on their past incomes.
“Friedman argues that it would be more sensible for people to use current income, but also at the same time to form expectations about future levels of income and the relative amounts of risk.”2
Further models can be analysed to determine whether an investment should be made and by looking at such models the individual will be assisted in predicting future occurrences. The marginal efficiency of investment (MEI) is a good example. The theory behind this model states that if the cost of an investment is greater than the expected returns then the amount one allocates towards investment should be decreased. On the other hand, if the expected returns exceed the total cost of investment then investment should be increased. This is particularly useful to a business when it must decide upon investment. Tobin’s q is a further model.
“Firms base investment decisions on value of outstanding stock relative to replacement cost of capital. Market value of current capital depends upon the value of firms shares, which in turn depends upon expectation of future profits from this capital”3
This model, therefore, is only of great use to a company with a stock listing. It shows that a company should increase investment if the stock market values it at more than the cost to replace all its capital and that it should continue to do so until an equilibrium is met, whereby the stock market valuation equals the cost of replacement capital.
The argument put forward seems to agree with the viewpoint that expectations of the future can have a major impact upon consumption an investment decisions made by individuals. Indeed, many macroeconomic functions support the idea. Evidence suggests that if one has or expects an increase in real income then consumption will be increased, whilst the marginal propensity to save decreases. Maybe the opposite will occur if individuals expect real income to decrease in the near future. Interest rates and its expectations can be of importance to the decision an individual makes regarding consumption or investment. Furthermore, the individual’s level of wealth can have a bearing; if one has a high level of wealth then a greater percentage may be used for consumption purposes.
References
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Visited – 3rd March 05
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Visited – 7th March 05
3. The University of Reading, Part 1: Introductory Economics 2 Handout
Andrew Powell Economics Essay – Consumption & Investment Page