Investment Function in an Economy: Importance, Types and Determinants

Read this article to learn about the importance, types and determinants of investment function in an economy.

Importance:

The level of income, output and employment in an economy depends upon effective demand, which in turn, depends upon expenditures on consumption goods and investment goods (Y = C + I).

Consumption depends upon the propensity to consume, which, we have learnt, in more or less stable in the short period and is less than unity. Greater reliance, therefore, has to be placed on the other constituent (investment) of income.

Out of the two components (consumption and investment) of income, consumption being stable, fluctuations in effective demand (income) are to be traced through fluctuations in investment. Investment, thus, comes to play a strategic role in determining the level of income, output and employment at a time.

We can establish the importance of investment in another way also. In order to maintain an equilibrium level of income (Y = C + I), consumption expenditures plus investment expenditures must equal the total income (Y); but according to Psychological Law of Consumption given by Keynes, as income increases consumption also increases but by less than the increment in income. This means that a part of the increment in income is not spent but saved.

The savings must be invested to bridge the gap between an increase in income and consumption. If this gap is not plugged by an increase in investment expenditures, the result would be an unintended increase in the stocks of goods (inventories), which in turn, would lead to depression and mass unemployment. Hence, investment rules the roost. In Keynesian economics investment means real investment i.e., investment in the building of new machines, new factory buildings, roads, bridges and other forms of productive capital stock of the community, including increase in inventories.

It does not include the purchase of existing stocks, shares and securities, which constitute merely an exchange of money from one person to another. Such an investment is merely financial investment and does not affect the level of employment in an economy. An investment is termed real investment only when it leads to a increase in the demand for human and physical resources, resulting in an increase in their employment. Investment is a flow variable and its counterpart is stock variable called capital.

Types of Investment:

Investment may be private investment or public investment, it may be induced or autonomous. Induced investment is that investment which changes with a change in income, that is why it is called income, elastic. In a free enterprise capitalist economy, investments are induced by profit motive. Such investment is very responsive to changes in income, i.e., induced investment increases as income increases. The shape of the induced investment curve, therefore, is upward sloping, indicating a rise in investment as a result of rise in income.

According to Hicks, investment is of two types, induced as described above and autonomous— it is independent of variations in output. Explaining autonomous investment, Hicks remarks: “Public investment, investment which occurs in direct response to inventions and much of the long range investment (as Mr. Harrod calls it) which is only expected to pay for itself over a long period, all of these can be regarded as autonomous investments.”

Autonomous investment is not sensitive to changes in income. In other words, it is independent of income changes and is not guided or induced by profit motive only. Autonomous investments are made primarily by the Government and are not based on considerations of profit.

Autonomous investments are a peculiar feature of a war or a planned economy, for example, expenditures on arms and equipment to strengthen the defence of India may be called autonomous investment as it is incurred irrespective of the level of income or profits. Prof. Hansen maintained that autonomous investment is generally associated with such factors as introduction of new production techniques, products, development of new resources or growth of population.

Induced investment is undertaken specially to produce large output. The curve of autonomous investment is represented by a straight line running from left to right and parallel to the horizontal income axis. The distinction between induced and autonomous investment is shown in Fig. 18.1.

Gross Investment and Net Investment:

Investment, as we have seen which is in the nature of How of expenditures, during a given time period, on view fixed capital goods or is in the nature of an addition to the stock of raw materials and unsold consumer goods is called gross investment. However, replacement of investment denotes to the expenditures incurred to maintain the stock of capital, in an economy, intact. This type of expenditure is undertaken to offset the depreciation, wear and tear and obsolescence in the existing productive capacity. Net investment is, thus, the excess of gross investment over the replacement investment. The term net investment is, therefore, sometimes used for capital formation also.

Symbolically:

I_g = I_n + I_r

where I_g is the gross investment, I_n the net investment and I_r the replacement investment also called capital consumption. It is the variations in the I_n which causes fluctuations in Y, O and E both in the short-run and in the long-run. If during a period I_g> I_r, it means that I_n is positive and the stock of capital is increasing equal to I_n thereby leading to an increase in the capacity to produce. If I_r > I_g, then I_n is negative and the stock of capital may decrease having unfavourable effects on the productive capacity. If, however, I_g = I_r, then I_n = O and it means that the economy is just making good the loss in capacity to produce on account of obsolescence and depreciation.

It may not be out of place to mention that net investment may also include expenditures on new durable consumer goods besides the expenditure on new capital goods. Therefore, in a sense, it would be more appropriate to define net investment as the net addition to the stock of capital including the producer and durable consumer goods. Capital here means accumulation in the stock of plant and equipment held by business units. It is therefore, clear that for economic growth, that is, if the economy is to grow over time its capital stock must also grow.

Determinants of Investment:

Private investment (induced investment) depends upon the marginal efficiency of capital and the rate of interest. The marginal efficiency of capital, in turn, depends upon future expectations which fluctuate violently. Hence, private investment becomes highly capricious and is very low, when in fact, it should be very high.

Prospective entrepreneurs keep on comparing the marginal efficiency of capital with the rate of interest and decide to invest only when the former is higher than the later. There will be no investment if the rate of interest is higher than the MEC. (In other words, if profit expectations are not very bright); that is the reason why investments fall to low levels during depression period, despite the fact that all types of encouragements are given to private investors to invest more.

Classical economists regarded investment as dependent on the rate of interest; this to them was an important lever by which investment in the system was regulated. This is why they relied too heavily on the rate of interest to control fluctuations. They always held that by manipulating the rate of interest, stability in the economic system could be restored. Until the Great Depression of the 1930s.

Keynes also adhered to this view and believed in the efficacy of the rate of interest in solving the problem of cyclical fluctuations. But later on, he realized its weaknesses and stopped giving it undue importance as cyclical stabilizer. Keynes realized that investment depended more on the psychological factors like the marginal efficiency of capital and not on the rate of interest; as such, it was relegated to the background. It is, no doubt, true that the marginal efficiency of capital has become the chief determinant of investment yet the influence of interest cannot be ignored as both go to determine it.

The significant role of public investment, also called the autonomous investment, which the Government may incur to save the economy from falling further to lower income levels, comes to the forefront. In the nature of the case, public investment is independent of the profit motive. Since a steady investment is essential for the investment multiplier to have positive effect on income, output and employment, during depression, motives other than profit are necessary to guide more investment— a function which is fulfilled only by public investment. Further, the amount of public investment cannot only be controlled but is capable of expansion to such an extent to make the investment multiplier work with greater force than would otherwise be possible.

Moreover, the government can prevent it from leaking out of the spending stream, as well as is capable of timing it, so as to let the multiplier have its full and free play. There is no reason why public investment should not be wealth- creating as well as employment-generating and why its adverse tertiary effects (if any) cannot be offset as a result of the beneficial effects of multiplier on private consumption. Hence, the importance of public investment. It, therefore, becomes necessary to analyze the various measures which stimulate investment.