INVESTMENT FUNCTION

According to Keynes:
• Investment in existing assets/ Investment in new assets

• Addition made to the existing capital asset which results in an

increase in employment.
• Thus, investment is the expenditure incurred for real capital
formation. It includes three kinds of items: 1) Building of new
machines and new capital equipment's, 2) Construction of new
buildings and 3) increase in stocks.
Classification of investment:
• Induced and autonomous investment
• Private and public investment

• Gross and Net investment

• Intended or Ex-ante or Planned investment/ Unintended or Ex-post or

Unplanned or Involuntary investment
Propensity to invest
• API = I / Y

• MPI = I / Y
Inducement to investment
• Motivation to increase investment is called inducement invest.

• DETERMINANTS OF INVESTMENT
a) MEC( Marginal efficiency of capital)
b) I (Rate of interest)
 Marginal Efficiency of Capital (MEC)

• The marginal efficiency of capital displays the expected rate of return

on investment, at a particular given time.

• Keynes relates the prospective yield of a capital asset to its supply

price and defines MEC “as being equal to that rate of discount which
would make the present value of the series of annuities given by the
returns expected from the capital asset during its life equal to its
supply price”. This may be put in the form of an equation.
 Where Sp is the supply price or the cost of capital asset, R 1,R2… Rn are the prospective
yields or the series of expected annual returns from the capital asset in the years 1,2……..
n, and i is the rate of return.

Let us assume that:

1. The life time of a capital asset (n) is 2 years.
2. The supply price of the capital asset (Sp) is Rs. 3000.
3. The expected yield from the asset at the end of one year (R 1)
is Rs. 1100.
4. The expected yield from the asset at the end of 2 years (R 2) is
Rs. 2420.
The MEC or the rate of discount which will equate the
future yields of the asset with its supply price is 10% as
shown below:
 MEC CURVE

Reasons
Increase in
Investment will lead
Law of to Increase in Cost &
Diminishing Price of product.
marginal returns Owing to increase in
cost the returns
decrease.

INVESTMENT DEMAND CURVE

To finance investment, firms will either
borrow or reduce savings. If interest rates
are lower, it’s cheaper to borrow, or their
savings give a lower return making If the rate of interest is 5%,
investment relatively more attractive. then only projects with a
rate of return of greater
than 5% will be profitable.
MEC: It refers to the expected profitability by the use
of one more unit of capital. It depends on two factors:
1) Prospective Yield: prospective yield of a capital good like, machine ,means that net income
which is available during the full life-time of that machine. In order to estimate net income, cost is
deducted from the annual output of machine. Total prospective yield is calculated by aggregating net
income of every year of a machine throughout its life-time.

2) Supply Price: Supply price refers to the cost of a machine, but it is not the cost of existing
machine but that of a brand new machine.

MEC can be ascertained by deducting supply price from prospective yield. Supply price remains
fixed at any given time, hence MEC is influenced more by prospective yield which is uncertain. It is
uncertain because it is mainly influenced by short term and long term expectations.
3) Rate of Interest: It is the cost of money invested
Investment decision
• If

MEC i = Investment will be made

MEC i = No investment will be made

MEC = i = Break even point

Factors influencing investment
• Technological advance and innovation
• Discovery of natural resources
• Government policies
• Foreign trade
• Political environment
• Expectations
• Rate of population growth
• Territorial expansion
• Price level
• Market structure
• Availability of finance
• Conditions in the labour market
• Present stock of capital goods
• Aggregate demand
• Factors influencing investment in public sector
Measures to stimulate private investment
• Reduction in the rate of interest
• Reduction in taxes
• Policy of wage cut
• Increase in government expenditure
• Price support policy
• Abolition of monopolistic tendencies
• Promotion of research
• Pump priming
Sources to stimulate public investment
• Taxation
• Loans
• Deficit financing
Importance of investment
• Determination of income and employment

• Volatile factor

• Economic development