Investment Function in an Economy: Importance, Types and Determinants

Investment Function.

The volume of investment function varies inversely with rate of interest.

So the investment function may fee expressed as:

Here I is (autonomous) investment and r is the market rate of interest.

The investment function refers to investment -interest rate relationship. There is a functional and inverse relationship between rate of interest and investment. The investment function slopes downward.

I= Investment (Dependent variable)

r = Rate of interest (Independent variable)

As a general rule the lower is the rate of interest, the large the number of profitable investment oppor­tunities and, consequently, the greater the investment expenditure that firms will like to make. In short, the volume of desired investment expenditure is nega­tively related to the rate of interest, rising as the rate of interest falls.

Importance:

The level of income, output and employment in an economy depends upon effective demand, which in turn, depends upon expenditures on consumption goods and investment goods (Y = C + I).

Consumption depends upon the propensity to consume, which, we have learnt, in more or less stable in the short period and is less than unity. Greater reliance, therefore, has to be placed on the other constituent (investment) of income.

Out of the two components (consumption and investment) of income, consumption being stable, fluctuations in effective demand (income) are to be traced through fluctuations in investment. Investment, thus, comes to play a strategic role in determining the level of income, output and employment at a time.

We can establish the importance of investment in another way also. In order to maintain an equilibrium level of income (Y = C + I), consumption expenditures plus investment expenditures must equal the total income (Y); but according to Psychological Law of Consumption given by Keynes, as income increases consumption also increases but by less than the increment in income. This means that a part of the increment in income is not spent but saved.

The savings must be invested to bridge the gap between an increase in income and consumption. If this gap is not plugged by an increase in investment expenditures, the result would be an unintended increase in the stocks of goods (inventories), which in turn, would lead to depression and mass unemployment. Hence, investment rules the roost. In Keynesian economics investment means real investment i.e., investment in the building of new machines, new factory buildings, roads, bridges and other forms of productive capital stock of the community, including increase in inventories.

It does not include the purchase of existing stocks, shares and securities, which constitute merely an exchange of money from one person to another. Such an investment is merely financial investment and does not affect the level of employment in an economy. An investment is termed real investment only when it leads to a increase in the demand for human and physical resources, resulting in an increase in their employment. Investment is a flow variable and its counterpart is stock variable called capital.

Types of Investment:

Investment may be private investment or public investment, it may be induced or autonomous. Induced investment is that investment which changes with a change in income, that is why it is called income, elastic. In a free enterprise capitalist economy, investments are induced by profit motive. Such investment is very responsive to changes in income, i.e., induced investment increases as income increases. The shape of the induced investment curve, therefore, is upward sloping, indicating a rise in investment as a result of rise in income.

According to Hicks, investment is of two types, induced as described above and autonomous— it is independent of variations in output. Explaining autonomous investment, Hicks remarks: “Public investment, investment which occurs in direct response to inventions and much of the long range investment (as Mr. Harrod calls it) which is only expected to pay for itself over a long period, all of these can be regarded as autonomous investments.”

Autonomous investment

Autonomous investment is the expenditure on capital formation, which is independent of the change in income, rate of interest or rate of profit.This investment is independent of economic activity. Autonomous investment is income-inelastic, the volume of autonomous investment is the same at all levels. The autonomous investment curve is horizontal, parallel to X axis. Investment that is not dependent on the national income, Mainly done with the welfare motive and not for making profits, Examples : Construction of road, bridges, School, Charitable houses, Not affected by rise in raw materials or wages of workers, Essential to development of nation and out of depression.

Autonomous investment is not sensitive to changes in income. In other words, it is independent of income changes and is not guided or induced by profit motive only. Autonomous investments are made primarily by the Government and are not based on considerations of profit.Autonomous investments are a peculiar feature of a war or a planned economy, for example, expenditures on arms and equipment to strengthen the defence of India may be called autonomous investment as it is incurred irrespective of the level of income or profits. Prof. Hansen maintained that autonomous investment is generally associated with such factors as introduction of new production techniques, products, development of new resources or growth of population.

Induced investment

Induced investment is the expenditure on fixed assets and stocks which are required when level of income and demand in an economy goes up. Induced investment is profit motivated. It is related to the changes of national income. The relationship between the national income and induced investment is positive; decreases in national income leads to decrease in induced investment and vice versa. Induced investment is income elastic. It is positively sloped as shown in figure.

Induced investment is undertaken specially to produce large output. The curve of autonomous investment is represented by a straight line running from left to right and parallel to the horizontal income axis.

The distinction between induced and autonomous investment is shown in Fig. 18.1.

Determinants of Investment Function

The classical economists believed that investment depended exclusively on rate of interest. In reality investment decision depends on a number of factors. They are as follows:

1.        Rate of interest

2.        Level of uncertainty

3.        Political environment

4.        Rate of growth of population

5.        Stock of capital goods

6.        Necessity of new products

7.        Level of income of investors

8.        Inventions and innovations

9.        Consumer demand

10.   Policy of the state

11.   Availability of capital

12.   Liquid assets of the investors

However, Keynes contended that business expectations and profits are more important in deciding investment. He also pointed out that investment depends on MEC (Marginal Efficiency of Capital) and rate of interest.

i. Private investment is an increase in the capital stock such as buying a factory or machine.

The marginal efficiency of capital (MEC) states the rate of return on an investment project. Specifically, it refers to the annual percentage yield (output) earned by the last additional unit of capital.

ii. If the marginal efficiency of capital is 5% and interest rates is 4%, then it is worth borrowing at 4% to get an expected increase in output of 5%.

Gross Investment and Net Investment:

Investment, as we have seen which is in the nature of How of expenditures, during a given time period, on view fixed capital goods or is in the nature of an addition to the stock of raw materials and unsold consumer goods is called gross investment. However, replacement of investment denotes to the expenditures incurred to maintain the stock of capital, in an economy, intact. This type of expenditure is undertaken to offset the depreciation, wear and tear and obsolescence in the existing productive capacity. Net investment is, thus, the excess of gross investment over the replacement investment. The term net investment is, therefore, sometimes used for capital formation also.

Symbolically:

Ig = In + Ir

where Ig is the gross investment, In the net investment and Ir the replacement investment also called capital consumption. It is the variations in the In which causes fluctuations in Y, O and E both in the short-run and in the long-run. If during a period Ig> Ir, it means that In is positive and the stock of capital is increasing equal to In thereby leading to an increase in the capacity to produce. If Ir > Ig, then In is negative and the stock of capital may decrease having unfavourable effects on the productive capacity. If, however, Ig = Ir, then In = O and it means that the economy is just making good the loss in capacity to produce on account of obsolescence and depreciation.

It may not be out of place to mention that net investment may also include expenditures on new durable consumer goods besides the expenditure on new capital goods. Therefore, in a sense, it would be more appropriate to define net investment as the net addition to the stock of capital including the producer and durable consumer goods. Capital here means accumulation in the stock of plant and equipment held by business units. It is therefore, clear that for economic growth, that is, if the economy is to grow over time its capital stock must also grow.

Relationship between rate of interest and Investment:

An explanation of how the rate of interest influences the level of investment in the economy. Typically, higher interest rates reduce investment, because higher rates increase the cost of borrowing and require investment to have a higher rate of return to be profitable.

As the real cost of borrowing rises, fewer investment projects are profitable.

If interest rates rise from 5% to 8 %, then we get a fall in the amount of investment from ? 100 cr to ? 80 cr.

If interest rates are increased then it will tend to discourage investment because investment has a higher opportunity cost.

1. With higher rates, it is more expensive to borrow money from a bank.

2. Saving money in a bank gives a higher rate of return. Therefore, using savings to finance investment has an opportunity cost of lower interest payments.

If interest rates rise, firms will need to gain a better rate of return to justify the cost of borrowing using savings.

The decision to invest in a new capital asset depends on whether the expected rate of return on the new investment is equal to or greater or less than the rate of interest to be paid on the funds needed to purchase this asset. It is only when the expected rate of return is higher than the interest rate that investment will be made in acquiring new capital assets.

In reality, there are three factors that are taken into consideration while making any investment decision. They are the cost of the capital asset, the expected rate of return from it during its lifetime, and the market rate of interest. Keynes sums up these factors in his concept of the marginal efficiency of capital (MEC).