The Investment Function: Meaning,

Types, Determinants and Distinction

1. Meaning of Capital and Investment:
In ordinary parlance, investment means to buy shares, stocks, bonds
and securities which already exist in stock market. But this is not real
investment because it is simply a transfer of existing assets. Hence this
is called financial investment which does not affect aggregate
spending. In Keynesian terminology, investment refers to real
investment which adds to capital equipment.
It leads to increase in the levels of income and production by
increasing the production and purchase of capital goods. Investment
thus includes new plant and equipment, construction of public works
like dams, roads, buildings, etc., net foreign investment, inventories
and stocks and shares of new companies. In the words of Joan
Robinson, By investment is meant an addition to capital, such as
occurs when a new house is built or a new factory is built. Investment
means making an addition to the stock of goods in existence.
Capital, on the other hand, refers to real assets like factories, plants,
equipment, and inventories of finished and semi-finished goods. It is
any previously produced input that can be used in the production
process to produce other goods. The amount of capital available in an
economy is the stock of capital. Thus capital is a stock concept.
To be more precise, investment is the production or acquisition of real
capital assets during any period of time. To illustrate, suppose the
capital assets of a firm on 31 March 2004 are Rs 100 crores and it
invests at the rate of Rs 10 crores during the year 2004-05. At the end
of the next year (31 March 2005), its total capital will be Rs 110 crores.
Symbolically, let I be investment and be capital in year t, then I t =
Kt- Kt- 1.

Capital and investment are related to each other through net

investment. Gross investment is the total amount spent on new capital
assets in a year. But some capital stock wears out every year and is
used up for depreciation and obsolescence. Net investment is gross
investment minus depreciation and obsolescence charges for
replacement investment. This is the net addition to the existing capital
stock of the economy.
If gross investment equals depreciation, net investment is zero and
there is no addition to the economys capital stock. If gross investment
is less than depreciation, there is disinvestment in the economy and
the capital stock decreases. Thus for an increase in the real capital
stock of the economy, gross investment must exceed depreciation, i.e.,
there should be net investment.

2. Types of Investment:
1. Induced Investment:
Real investment may be induced. Induced investment is profit or
income motivated. Factors like prices, wages and interest changes
which affect profits influence induced investment. Similarly demand
also influences it. When income increases, consumption demand also
increases and to meet this, investment increases. In the ultimate
analysis, induced investment is a function of income i.e., I = f(Y). It is
income elastic. It increases or decreases with the rise or fall in income,
as shown in Figure 1.

I1 I1is the investment curve which shows induced investment at various

levels of income. Induced investment is zero at OY1 income. When
income rises to OY3 induced investment is I3Yy A fall in income to
OY2also reduces induced investment to I2Y2.
Induced investment may be further divided into (i) the average
propensity to invest, and (ii) the marginal propensity to invest:
(i) The average propensity to invest is the ratio of investment to
income, I/Y. If the income is Rs. 40 crores and investment is Rs. 4
crores, I/Y = 4/40 = 0.1. In terms of the above figure, the average
propensity to invest at OY3 income level is I3Y3/ OY3
(ii) The marginal propensity to invest is the ratio of change in
investment to the change in income, i.e.,
I/
Y. If the change in
investment,

I=Rs 2 crores and the change in income,

Y = Rs 10

crores, then

I/Y = 2/10=0.2 In Figure 1, I/ Y =I3a/Y2Y3

2. Autonomous Investment:
Autonomous investment is independent of the level of income and is
thus income inelastic. It is influenced by exogenous factors like
innovations, inventions, growth of population and labour force,
researches, social and legal institutions, weather changes, war,
revolution, etc. But it is not influenced by changes in demand. Rather,
it influences the demand. Investment in economic and social
overheads whether made by the government or the private enterprise
is autonomous.

Such investment includes expenditure on building, dams, roads,

canals, schools, hospitals, etc. Since investment on these projects is
generally associated with public policy, autonomous investment is
regarded as public investment. In the long-run, private investment of
all types may be autonomous because it is influenced by exogenous
factors. Diagrammatically, autonomous investment is shown as a
curve parallel to the horizontal axis as I1I curve in Figure 2. It
indicates that at all levels of income, the amount of investment
OI1 remains constant.

The upward shift of the curve to I2I indicates an increased steady flow
of investment at a constant rate OI2 at various levels of income.
However, for purposes of income determination, the autonomous
investment curve is superimposed on the curve in a 45 line
diagram.

3. Determinants of the Level of Investment:

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).
Marginal Efficiency of Capital:
The marginal efficiency of capital is the highest rate of return expected
from an additional unit of a capital asset over its cost. In the words of
Kurihara, It is the ratio between the prospective yield to additional
capital goods and their supply price. The prospective yield is the
aggregate net return from an asset during its life time, while the
supply price is the cost of producing this asset.
If the supply price of a capital asset is Rs. 20,000 and its annual yield
is Rs. 2,000, the marginal efficiency of this asset is 2000/20000
100/1 = 10 per cent. Thus the marginal efficiency of capital is the
percentage of profit expected from a given investment on a capital
asset.
Keynes relates the prospective yield of a capital asset to its supply
price and defines the MEC as equal to the rate of discount which
would make the present value of the series of annuities given by the
returns expected from the capital assets during its life just equal to its
supply price.
Symbolically, this can be expressed as:
SP =R1/ (1+i) + R2 (1+i)2 + Rn/(1+i)n
Where Sp is the supply price or the cost of the capital asset, R 1 R2
and Rn are the prospective yields or the series of expected annual
returns from the capital asset in the years, 1, 2 and n, i is the rate of
discount which makes the capital asset exactly equal to the present
value of the expected yield from it.
This i is the MEC or the rate of discount which equates the two sides of
the equation. If the supply price of a new capital asset is Rs 1,000 and
its life is two years, it is expected to yield Rs 550 in the first year and
Rs 605 in the second year. Its MEC is 10 per cent which equates the
supply price to the expected yields of this capital asset.
Thus

(Sp) Rs 1000 = 550/(1.10) + (605)/(1.10)2 = Rs. 500 + 500

In equation (1), the term R1/(1+i) is the present value (PV) of the
capital asset. The present value is the value of payments to be
received in the future. It depends on the rate of interest at which it is
discounted.
Suppose we expect to receive Rs 100 from a machine in a years time
and the rate of interest is 5 per cent. The present value of this machine
is
R1 / (1+ i) =100/(1.05) = Rs 95.24
If we expect Rs 100 from the machine after two years then its present
value is100/ (1.05)2 = Rs 90.70. The present value of a capital asset is
inversely related to the rate of interest. The lower the rate of interest,
the higher is the present value, and vice versa. For instance, if the rate
of interest is 5 per cent, PV of an asset of Rs 100 for one year will be Rs
95.24; at 7 per cent interest rate, it will be Rs 93.45; and at 10 per cent
interest rate, it will be Rs 90.91.
The relation between the present value and the rate of interest is
shown in Figure 3, where the rate of interest is taken on the horizontal
axis while the present value of the project on the vertical axis. The
curve PR shows the inverse relation between the present value and the
rate of interest. If the current rate of interest is ii the present value of
the project is P1 On the other hand, a higher rate of interest (i2) will
lead to a lower present value (P2) when the present value curve (PR)
cuts the horizontal axis at point (Z), the net present value becomes
zero.

As a matter of fact, the MEC is the expected rate of return over cost of
a new capital asset. In order to find out whether it is worthwhile to
purchase a capital asset it is essential to compare the present value of
the capital asset with its cost or supply price. If the present value of a
capital asset exceeds its cost of buying, it pays to buy it. On the
contrary, if its present value is less than its cost, it is not worthwhile
investing in this capital asset.
The same results can be had by comparing the MEC with the market
rate of interest. If the MEL of a capital asset is higher than the market
rate of interest at which it is borrowed, it pays to purchase the capital
asset, and vice versa. If the market interest rate equals the MEC of the
capital asset, the firm is said to possess the optimum capital stock.
If the MEC is higher than the rate of interest, there will be a tendency
to borrow funds in order to invest in new capital assets. If the MEC is
lower than the rate of interest, no firm will borrow to invest in capital
assets. Thus the equilibrium condition for a firm to hold the optimum
capital stock is where the MEC equals the interest rate.
Any disequilibrium between the MEC and the rate of interest can be
removed by changing the capital stock, and hence the MEC or by
changing the rate of interest or both. Since the stock of capital changes
slowly, therefore, changes in the rate of interest are more important

for bringing equilibrium. The above arguments which have been

applied to a firm are equally applicable to the economy.
Figure 4 shows the MEC curve of an economy. It has a negative slope
(from left to right downward) which indicates that the higher the
MEC, the smaller the capital stock. Or, as the capital stock increases,
the MEC falls. This is because of the operation of the law of
diminishing returns in production.

As a result, the marginal physical productivity of capital and the

marginal revenue fall. In the figure, when the capital stock is OK1, the
MEC is Or1. As the capital increases from OK1to K2 the MEC falls
from Or1 to Or2.The net addition to the capital stock K1K2 represents
the net investment in the economy.
Further, to reach the optimum (desired) capital stock in the economy,
the MEC must equal the rate of interest. If, as shown in the figure, the
existing capital stock is OK1 the MEC is Or2 and the rate of interest is
at Or1 Everyone in the economy will borrow funds and invest in capital
assets.
This is because MEC (Or1) is higher than the rate of interest (at Or2).
This will continue till the MEC (Or1) comes down to the level of the
interest rate (at Or2). When the MEC equals the rate of interest, the
economy reaches the level of optimum capital stock. The fall in the
MEC is due to the increase in the actual capital stock from OK2 to the
optimum (desired) capital stock OK2.

The increase in the firms capital stock by K1K2 is the net investment of
the firm. But it is the rate of interest which determines the size of the
optimum capital stock in the economy. And it is the MEC which
relates the amount of desired capital stock to the rate of interest. Thus
the negative slope of the MEC curve indicates that as the rate of
interest falls the optimum stock of capital increases.