Investment Function

Investment Function
Introduction
• According to Keynes “investment implies creation of new capital
assets or additions to the existing stock of productive assets. It refers
to that part of the aggregate income, which is used for the creation of
new structures, new capital equipments, machines etc that help in
the production of final goods and services in an economy. Creation of
income – earning assets is called investment.“
Determinants of Investment
• Revenues: an investment should bring the firm additional

revenue.
• Costs: interest rate influences the costs of the investment.
• Consumer demand: the bigger the increase in consumer
demand, the more investment will be needed.
• Expectation: business expectation about future state of
economy.
Introduction
• The investment function is a summary of the variables that influence the level of
aggregate investments.
• It can be formalized as follows:

• I=f(r, є)
• R= rate of interest
• є= expected rate of return on investment
• The demand for capital, I, is inversely related to the cost of capital, r.
• Businesses borrow to purchase investment goods.
• Higher the interest rates, lower is the profitability of the investment.
• Hence, firms want to borrow and invest more when interest rate is lower; this implies an
inverse relationship between rate of interest and investment.
• The demand of capital to be invested is directly related to the
expected rate of return on investment.
• >0
Types Of Investment
• Private Investment.
• It is made by private entrepreneurs on the purchase of different capital assets like
machinery, plants, construction of houses and factories, offices, shops, etc.
• Profit motive is the basis for private investment.
• Private entrepreneurs would take up only those projects, which yield quick results and
generally have small gestation period.
Public Investment
• It is undertaken by the public authorities like Central, State and Local authorities.
• It is made on building up of infrastructure of the economy, public utilities and on social goods.
• For example expenditure on basic industries, defense industries, construction of multi purpose
river valley projects, etc. In this case the basic criterion and
• Motto is social net gain, social welfare and not profit motive.
• The principle of maximum social advantage would govern public expenditure. It is influenced by
social and political considerations also.
Induced Investment
• It is another name for private investment.
• Investment, which varies with the changes in the level of national income, is called
induced investment.
• When national income increases, the aggregate demand and level of consumption of the
community also increases. In order to meet this increased demand, investment has to be
stepped up in capital goods sector which finally leads to increase in the production of
consumption goods.
• It is sensitive to changes in income and is governed by profit – motive.

The shape of the induced investment curve has been shown as rising upwards to the
right. This means that as income increases, investment also increases and vice versa.
Autonomous Investment
• It is another name for public investment.
• The investment, which is independent of the level of income, is called as autonomous

investment.
• Such investments do not vary with the level of income. Therefore it is called income
inelastic.
• It does not depend on changes in the level of income, consumption, rate of interest or
expected profit.
• It is guided by social welfare rather than profit motive

Pump Priming
• Pump priming is the action taken to stimulate an economy, usually during a
recessionary period, through government spending, and interest rate and tax
reductions.
• Pump priming states that government intervention within the economy, aimed at
increasing aggregate demand, can result in a positive shift within the economy.
• This is based on the cyclic nature of money within an economy, in which one
person’s spending directly relates to another person’s earnings, and that increase
in earnings leads to a subsequent increase in spending.
The Simple Theory of Investment
• In the simple Keynesian model, investment is

independent of national income (autonomous
investment).
• The investment function will be a horizontal
straight line.
The Investment Function
I In the short-run it
is reasonable to
assume that
investment is
I2 independent of
I2
national income.
I1
I1
0 Y
Investment Multiplier
• The Keynesian investment multiplier model

shows that an increase in investment will increase
output by a multiplied amount – by an amount
greater than itself.
• The multiplier is the number by which the
change in investment must be multiplied in
order to determine the resulting change in total
output.

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Investment Function

• Revenues: an investment should bring the firm additional

• It can be formalized as follows:

• Businesses borrow to purchase investment goods.

• Higher the interest rates, lower is the profitability of the investment.

• Profit motive is the basis for private investment.

• It is sensitive to changes in income and is governed by profit – motive.

• The investment, which is independent of the level of income, is called as autonomous

• It is guided by social welfare rather than profit motive

• In the simple Keynesian model, investment is

• The Keynesian investment multiplier model

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