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Investment is an asset or item acquired with the goal of generating income or appreciation. It is also the purchase of goods that are not consumed today but are used in the future to create wealth.
At the macro level, investment comprises of three major
factors:
§ Investment decisions made by business firms and organizations
§ Saving decisions made by the consumers
§ Decision on supply of investment goods by the producers of capital goods
Types of Investment
Generally, investment can be classified into two types. They are induced investment and autonomous investment.
An investment influenced by expected profit or rising levels of income in the economy is termed as induced investment. The factors that affect profits such as prices, wages, and interest influence induced investment. Likewise, it is also affected by demand. At higher levels of income, consumption expenditure (.i.e. demand) also tends to increase. Increased demand raises the expected profitability of the producers who are consequently induced to make more investment.Induced Investment
Thus, induced investment is positively related to the levels of income in an economy. It increases with the rise in income and falls as income declines.
The diagram below provides a clear explanation
The diagram shows that with the increase in the level of income from Y1 to Y2, the level of induced income also increased from I1 to I2.
Autonomous Investment
An investment not influenced by expected profitability of level of income is termed as autonomous investment. It is an investment expenditure made by the government with a view of promoting the level of aggregate demand in the economy.
When the level of aggregate demand falls short of the aggregate supply, the government tends to push up the level of aggregate demand through various governmental investment expenditures. Such investment is thus not influenced by profitability and so is independent of the level of income.
Diagrammatically,
OI is the level of autonomous investment and the horizontal line IIa indicates the Oi level of investment that remained unaffected by the level of income.
Determinants of Investment
Induced investment is influenced by endogenous factors such as income level, propensity to consume, stock of fixed capital, etc. While autonomous investment is influenced by exogenous factors. Since gross investment in the economy is the sum of induced investment and autonomous investment, it is determined by both endogenous and exogenous factors.According to Keynes, investment rate in the economy is mainly influenced by two factors, marginal efficiency of capital and rate of interest.
Marginal Efficiency of Capital (MEC)
Marginal efficiency of capital is defined as the productivity of capital. Generally, marginal efficiency of capital shows the cost of capital asset and the expected rate of return from additional investment made. If the rate of return on any prospective investment is greater than the cost of investment, the entrepreneur is bound to make the investment and vice versa.
Thus, Keynes pointed out MEC as an important factor in capital investment and highlighted on the following:
§ If MEC > r, then the investment project is acceptable
§ If MEC = r, then the investment project is acceptable on a non-profit basis
§ If MEC < r, then the investment project is rejected
Rate of Interest
Rate of interest refers to the cost of investment. If the rate of interest is high, investment is expensive. On the contrary, if the rate of interest is low, investment is considered to be cheaper. This shows that an inverse relationship exists between rate of interest and the profitability of investment. Subsequently, an inverse relationship exists between rate of interest and investment.
Classical economists considered that investment mainly depends on the rate of interest. However, Keynes emphasized on the marginal efficiency of capital as the most important factor that determines the investment. Since, interest rate normally remains constant, MEC is the determining factor of investment.
Adopted from: www.businesstopia.com
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