Investment Function

Concepts in Investment


Capital refers to any financial assets or real assets such as plants, equipment, factories, and inventories of semi-finished as well as finished goods that have financial value.

In economics, capital is usually referred to as the factors of production used for the production of goods and services. It can be defined as any produced good that can be stocked and used for further production of goods and services.


Investment in Keynesian economics refers to real investment which implies the creation of new factory buildings, roads, bridges and other forms of productive capital which directly generates new jobs and increases production.

The concept of investment is not expressed in terms of financial investment because it usually refers to capital ownership rights that are transferred from one person to another. It is undertaken on shares, bonds, etc. and results in no addition to the capital stock of the economy.

Investment and capital are interrelated. Precisely, net investment means the investment which results in an increase in capital stock. It is the excess of gross investment over depreciation.

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.

Induced 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.

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

Induced Investment

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.


Autonomous Investment

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 if 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.