The Financial System and Investment

<Last updated 12.04.2020>

Dear reader,

Hi! If you are interested in Economics, I’ve prepared the below to help your understanding relating to investments and savings. You should take a look at this short article in which I discuss about how the Financial System works and Investment.

What it means to invest? Investment is the transformation of savings into new capital goods (buildings, machinery, increase in inventories). In this case, consider that Private Investment for individuals does not necessarily increase capital goods (i.e. stock purchase, land, old buildings). It’s just a transfer of ownership.

There are different kind of investment categories depending on the type of capital:

a) Investment in Fixed Capital: machinery, buildings, equipment etc. These investments represent a big part of the total investment due to their importance in the production possibilities of the economy.

b) Investment in Stock/Inventory: raw materials, products etc. These investments take place for the smooth function of the production process and to serve customers efficiently.

c) Investment of Households in new Residences: These investments depend mainly from the provision of residential loans and the amount.

d) Government Investing in Infrastructure: Building schools, hospitals, roads, communications etc.

What are the factors affecting investment decisions? We have the following:

a) Expected Rate of Return: calculated by taking into account the cost of investment and the expected return generated by it. The higher the expected return the higher the investment amount. It is calculated as per below:

Expected Rate of Return (ERR) =  (Expected Return Amount (increase in profit) / “Cost” of Investment) x 100

b) The interest rate: This is cost for the business, so as higher the interest rate for borrowing is the higher the cost. If interest rate exceeds the expected rate of return to investment then investment won’t take place.  > this is if you compare i.e. ERR 20% versus 25% interest rate (on Investment).

c) The cost of investment: cost of investment depends on capital goods prices. So, if their prices get higher and higher then investment amounts will be lower and lower.

d) Taxation Policy and Taxation Motives: Imposing low taxes on business profits encourages investments because the rate of return to investment is higher.

The government can increase investments by reducing taxes on businesses profits. Other means include:

> Reduction of the costs of investment by providing funding. > Reduction on donations. Removal of fees,  for imported machinery and raw materials. Subsidies on Interest rates for reduction of business cost. Of course all of these reduce the Public Budget since is government expenditure in order to boost the economy, increase production/provision of goods and services.

e) Technological changes and innovations: Every technological change increases productivity, in result businesses profits increase. The expected return on capital increases and so investments increase.

What does innovation mean? the production of a new product or the growth of a new production process. It creates needs for capital goods and it is one of the most important factors boosting investments. (think about computers, telecommunication, robotics etc.)

f) Investor Expectations: Depending on what investors think about the future costs and benefits of ,investments they will either increase or decrease. These expectations are determined by the economic conditions of the country so if they are rational, they are looking at the economic indicators  and political stability (affecting their psychology and trust regarding the future).

“I hope I am clear on this one. If not, contact us on social media and we will do our best to help you.

Thank you for reading my articles and watching my videos.”

Marios Kyriakou