Investment and Economic Development 'Literature Review' chapter

Excerpt from 'Literature Review' chapter :

Private Sector Investment and Economic Development

Investment and economic development

The Role of Private Sector investment in Economic Development

In the past few decades there has been overwhelming support for growth and development rooted in private investments and market-oriented strategies. A move from public sector driven growth has come as result of the need to reduce the widening gap in the balance of payment account, increasing public debt, rising inflation rate, growing foreign debt fundamentally falling living standards. There has been a shift from the need for large public corporations undertaking productive activities in an economy owing to the realized inefficiency in resource allocation. Corruption and misappropriation of public funds is observable owing to the lacking need to optimally reap benefit from the investment. Unlike in the public sector, private sector investment guarantees optimal productive activities, efficient allocation of productive resource, technological advancements to reduce cost and increase productivity (Dao, 2008).

Preferences for private investment to yield economic development have been advocated for in numerous theoretical models. Empirical evidences from studies in the developed and developing world have also come forth to support the theoretical models for private investment. UNDP has recently supported the need for public sector investment as an impetus to economic growth. It argues that no meaningful growth can be realized in an economy where private sector investment is missing (Harrison Jr. et al., 2012). Private sector investment is needful to share it expertise in knowledge access, business models, innovation and creation of employment. This opens up a developing country to a whole new spectrum in resource allocation, management and efficient productive activities (Harrison Jr. et al., 2012).

This section reviews the theoretical models of economic growth supporting private investment. The paper purposes to shed light on the need for private sector investment as a driver for economic growth in developing countries.

Keynesian Theory of Investment

Investment theories can be traced back to the era of Keynes classical economists. Keynes advocacy is on independent investment in the economy. The central feature in his theory is a saving and investment functions that need to be identical for growth to be realized (Keynes, 1936). This theory is relevant in the determination of the role played by the private sector owing to the value it places on saving as a measure for investment. The theory depict saving as a driving force to private investment given the potential it creates by allocating funds for private entrepreneurs. In the theory it is seen that private investment will result from the savings made in the economy allowing for private companies to borrow from financial institution at a lower cost.

This compared to a situation where there are no savings, the cost of borrowed funds is lower. It pushes down the cost of borrowing and motivates investors to undertake productive activities. The model by Keynes is touted as the initial theory of investment though it has come under heavy criticism owing to the fact it advocates for lower initial demand in the economy. The theory can be said to be suffice only in an economy where demand outstrips supply and the cost of capital is higher than the ability for investors to take up investment activities. The theory by Keynes advocating for saving show that development is a result of savings that attract private investment. This notion plays a significant role for the current study to enlighten on ways of achieving private investment. Although the economy needs to have demand that outstrips supply the theory sheds light on the significance of savings in an economy to target development. This theory show the need for internal growth through saving and in his theory Keynes is showing how well an economy can arrive to equilibrium. In the theory there exists disequilibrium where demand outstrips supply. With increased savings in the economy there is potential for growth in output through investment and internal production. The economy will eventually come to equilibrium once the national output matches up with the national demand.

In the second evolution phase of Keynes investment theory brought about the accelerator theory that postulates investment and changes in output to have a linear proportional function. In this theory, profitability, expectation and cost of capital have no role to play in investment. The proponents of the Keynesian theory have been criticized to favor accelerated investment disregarding the cost of factors. The flexible accelerator model is the more general form of the accelerator theory. The model suggests that firms rate of investment is determined by the gap existing between the desired capital stock and the existing capital stock in the economy. In the theory is hypothesized that firms' objective is to close the gap between actual stock of capital (K) and the desired stock of capital K* in a given period. This brings about the investment formula as:

I = ? (K* - K-1)

In the formula I is the net investment, ? is the coefficient for partial adjustment, K* is the desired stock of capital, K-1is the stock capital help in the last period (Keynes, 1936). In the flexible investment accelerator model, the variable included as determinants of K* may be internal funds, output, cost of financing among other variables. (Jorgenson, 1971) among other theorist have incorporated the cost function to the neoclassical approach as advancement to the accelerator investment theory. In their approach the optimal capital stock is given as a proportion of the user cost of capital and output. This is depended in turn on the cost of real interest rate, the tax structure, depreciation cost of capital goods and the price capital goods.

Further emphasis to the importance of financial deepening and high interest rate to stimulate growth is proposed by neoliberal theorist (Shaw, 1973). Their arguments postulate that future private investment is based on the ability to postpone consumption in preference for savings currently. The high interest rate will increase the value for financial savings raising the potential for investable funds in the future. The core argument by the proponents of the neoliberal approach is developing countries suffer financial repression. This emanates from downward controls on interest rate. The liberation of developing countries from these repressive interest rate controls will bring about growth in the future by advocating for savings and thereafter inducing investment. A more efficient allocation of loanable funds will result on top of increasing its base. This will contribute to higher sustainable economic growth (Shaw, 1973).

A neoliberal approach to investment asserts real investment rate to be positively related to real interest rate contrasted to the neoclassical theory where cost of capital is omitted. The notion behind this is that as real interest rate rises, the willingness to save in financial intermediaries increases. This increases the funds available for borrowing and investment functions the "Conduit Effect" as McKinnon (1993) calls it. Although economic understanding tells us that the a rise in interest rate will lead to a decline in investment, realizable investment will increase owing to the increase availability of funds. The assumption for this preposition to apply is the capital market is at disequilibrium. This is a case that is mostly observed in the majority of the developing economies. McKinnon (1993) observes that in developing economies, demand for capital funds exceeds supply.

The observation by Mckinnon plays a significant contribution to the knowledge for advising investment and their decision. It also adds value to Keynes investment theory that requires for savings then investment to occur. Economic development requires a stable base in order to remain sustainable. The investment theory as discussed by Mckinnon adds value to the savings by incorporating the real cost of capital. This is what an investor will end up paying in real value for the funds borrowed. In the case where no borrowing of investment fund occurs savings in the economy create a value for the money market that helps to determine the real cost of money. This creates a notion of value to investors as this is what they consider to take investment decision.

The investment theory is further evaluated by other proponents to have some value of uncertainty. Investment in productive activities is considered irreversible to compensate for full amount invested. In the case (Pindyck, 1991) argue that since capital goods have a lower re-sale vale and are mostly firm specific, disinvestment is costly than investment. The argument in this case is that a firm cannot reverse an investment decision once market condition turn to be unfavorable. The prevailing conditions that firm invest when unit value is as large as its cost discourages the reveres since firm will incur a loss. The last option on unfavorable condition in the market should be included in the investment decision making as an opportunity cost. With this inclusion the value of the unit investment made is required to exceed the cost of purchase and installation by an amount equal to the value of maintaining the investment option in operation (Pindyck, 1991). This argument by Pindyck shows the aspects that advice investment decisions taken up.…

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