1. Investment refers to the net addition to existing capital assets like machines, factories, and plants that create additional employment. It does not include purchases of existing assets. 2. The level of investment is determined by the marginal efficiency of capital (MEC), which depends on the prospective yield of a capital asset and its supply price. Investment will occur when the MEC is higher than the prevailing interest rate. 3. Factors like expected demand, costs, interest rates, tax policies, financing constraints, technology, and business confidence influence the MEC and the volume of investment in both the short-run and long-run.

1. Investment and
Investment Function

2. Investment
Net addition to the existing stock of capital
assets
E.g. new machines, factories and plants
Does not refer to the purchase of existing
bonds, securities, debentures, etc.
Only real investment creates additional
employment

3. Effective Demand
ED = C + I
Consumption function is more or less
stable in the short-run
Investment is the strategic variable for
increasing employment

4. Characteristics of investment
Most volatile component of GDP from demand /
expenditure side
Pro-cyclical
Largely responsible for business cycles
Major determinant of economic growth
Dual role
Aggregate demand
Aggregate supply
Self terminating and self financing

5. Components of investment
Classified into three categories:
Fixed non-residential investment
Inventory investment
Fixed residential investments

6. Motivation for
Investment

7. Business fixed investment
Production requires factories & equipment –
firms must invest in order to produce
Increased production requires increased
investment in fixed assets unless they have idle
capacity
Firms tend to invest more when labour cost
relative to capital rental goes up
To emphasize innovations
Rental firms invest as they are in the business of
renting out these assets to production firms

8. Investment in inventories
Production Smoothing
Factor of production
Stock-out avoidance
Work-in-progress

9. Fixed Residential Investment
It is undertaken by households to own and
live in their own houses
Landlords invest as they are in the house-
renting business.

10. Investment and Capital
While investment is a flow, capital is a stock
Capital is cumulative net investment:
t
Kt = Σ Ii
i=1
where Kt = capital at time t
Ii = net investment made during time period i.

11. Net investment
= gross investment – depreciation
Capital is measured at a point of time
Point to note:
If it is measured at the beginning of the
period, it does not include investment
made in that period
If it is measured at the end of the period, it
is inclusive of current investment

12. Kinds of Investment

13. Public investment
Investment is autonomous
Quite arbitrary, i.e. without reference to
market conditions (MEC or rate of interest)

14. Private investment
Investment made by the private investors
– households or firms
Investment depends on market conditions
High during prosperity
Low during recession / depression

15. Determinants of
Investment
Private Investment

16. Volume of investment
Depends upon two factors:
Marginal efficiency of capital (MEC)
Rate of interest

17. Rate of interest does not change much –
sticky or constant
MEC determines the volume of investment
in a community
Fluctuations in investment are mainly due
to fluctuations in MEC

18. MEC
The expected profitability of a capital asset
Definition:
Highest rate of return over cost expected from
the marginal or additional unit of the capital
asset
Refers to
Marginal unit
Cost has to be deducted from returns

19. Two factors determine MEC
Prospective yield from capital asset
Supply price of capital asset

20. Prospective Yield of Capital
Total net returns expected from the asset
over its lifetime.
‘net’ means gross proceeds minus the
‘running costs’ of the asset
Add together the annual net returns
expected from the asset during its lifetime.

21. Points to note……
reference here is not to the actual but to the
expected annual returns from the asset.
the asset is not to be considered in the sense of
existing asset but in the sense of a brand new
asset.
all prospective net annual returns from an asset
(during its lifetime) may not be equal, unless we
assume the existence of a stationary or static
society.

22. Supply price
Supply price is the cost of producing a
brand new asset of that kind, not the
supply price of an existing asset.
The supply price of an asset is also
referred to as its replacement cost.

23. Determining MEC
Relating the two factors – prospective
yield and supply price – gives MEC of an
asset.
The MEC of an asset thus, means what an
investor expects to earn from an additional
unit of it compared with what it costs him.

24. Supply price = discounted prospective yield
R1 R2 Rn
Cr = -------- + --------- + ------+ ---------
(1+r) (1+r)2 (1+r)n
Where Cr = supply price of new capital asset
R1, R2 ---- = expected annual returns
r = rate of discount which makes present
value of the series of annual returns equal
to the supply price

25. Rate of Interest
Price paid for loanable funds
Determined by supply and demand for
loanable funds

26. MEC & Rate of Interest
Potential investor will weigh MEC on new
investment with rate of interest
MEC > rate of interest
Investment will be made
MEC = rate of interest
Equilibrium investment

27. Supply Annual MEC Rate of Effect on
Price Return Interest Investment
Rs. Rs. 4% 4% Neutral
25,000 1,000
Rs. Rs. 5% 4% Favourable
25,000 1,000
Rs. Rs. 4% 5% Adverse
25,000 1,000

28. At a Glance
Volume of Investment
MEC Rate of Interest
Supply Price Prospective Yield of Capital Demand for Funds Supply of Funds
Sale of output
Running costs

29. Factors Affecting
MEC

30. Short-run Factors
Expected demand
Costs and prices
Propensity to consume
Current state of expectation

31. Long-run Factors
Rate of growth of population
Development of new areas / markets
Technological progress
Productive capacity of existing capital
equipment
Rate of current investment

32. Investment Function
Investment expenditure depends
positively on the scale / financing / source
variable and its yield, e.g. output is the
scale variable, profitability the yield.
Varies negatively with its cost, e.g.
interest and depreciation rates.

33. I = f (Y, r, Q, FMP, F, T, BC, Y-1, K-1, µ)
Where I = net investment
Y = output / income
r = rate of interest
Q = Tobin’s Q
FMP = fiscal and monetary policy
F = financial constraints
T = technology
BC = business confidence
Y-1 = output in previous year
K-1 = stock of capital in previous year
µ = other factors

34. Output / income: investment is derived
demand - will vary positively with changes
in income
Interest rate: investment has negative
relationship with interest rate

35. Tobin’s Q
Nobel prize winning economist James Tobin
Market value of installed capital
Q = ------------------------------------------------
Replacement cost of installed capital
Q > 1: invest in more capital
Q < 1: investment will fall

36. Tax laws
Corporate tax: levied on business profits
(net of depreciation cost)
Income tax: rules permit exemption on
housing loans but not on rental income
Other fiscal policies: capital subsidy, tax
concessions/holidays

37. Financing constraints
Technology
Business confidence