Question

1) Explain carefully the Keynesian theory of investment.

2) Explain the quantity theory of money demand and discuss its main hypotheses.

Answer 1

Solution. 1. A realistic theory of investment should incorporate the assumption that the firm is a semiautonomous agent with a preference function of its own. We would expect the firm to pursue growth in size or market share and in profits -its growth objective - and avoid threats to its decision-making autonomy or its financial security - its safety objective. The existence of this safety objective makes the firm itself risk-averse.

Growth is attainable only through capital accumulation, but capital accumulation must be financed. Debt finance creates explicit, legally binding cash flow commitments to creditors. But even internal funding and stock flotation create implicit cash flow commitments to shareholders. If commitments to stockholders cannot be met out of the future operating profits generated by invested capital, management may experience a threat to its decision-making autonomy; if commitments to creditors are not met, the firm might go bankrupt. In a Keynesian world financial commitments, especially to creditors, are relatively certain while expected profits are not. With long-lived illiquid capital, the firm must form expectations of cash flows well into the future and must assess the quality of the expectations thus formed. But about such matters, “We simply do not know.”

When capital goods are illiquid the future is unknowable, serious mistakes are possible and the final commitments associated with them are irreversible. Thus, capital accumulation is simultaneously necessary and dangerous for the firm itself: it is necessary to achieve growth and defend its markets and its profits from aggressive competitors, and dangerous because disappointed expectations can make it difficult or even impossible for the firm to fulfill financial commitments.

Were firms to undertake only those investment projects with very high expected profit rates and low risk, they might be able to improve growth and safety prospects simultaneously. But as the firm considers projects with decreasing expected profits and increasing risk, the expected growth that increased investment promises will be associated with greater financial burdens and decreased safety. Conversely, if the firm maximized safety, it would forgo growth opportunities. Thus, the essence of management’s decision-making dilemma is that, at the margin, it confronts a growth-safety trade-off. Firms must seek a level of investment that achieves a satisfactory balance between their growth and safety objectives.

In a Keynesian model, then, investment will be determined by management’s preference for growth relative to safety and those variables that affect the perceived relation between investment and growth and between investment and safety. For example, the expected profit rate has a powerful influence on investment because a higher profit will, by increasing expected profits per unit of investment and by raising expected profit flows relative to cash flow commitments to owners and creditors, increase both growth and safety simultaneously.

On the other hand, increased financial leverage, higher interest rates, or a decrease in management’s confidence in its ability to foresee future economic conditions will depress investment because they lower the safety associated with every prospective investment project. The enterprise investment decision at a fixed point in time can be briefly characterized as follows: Ceteris paribus, a managerial preference for growth relative to safety, a high expected profit rate, financial robustness, low interest rates, and a minimal sense of uncertainty all stimulate investment, and vice versa.11 Specifying the determinants of investment at a point in time, however, is but the first step in the construction of a dynamic investment theory.

There are two potential endogenous sources of change in a Keynesian model: (1) conventional expectations and confidence formation; and (2) the effect that the investment decision in the aggregate might have on the value