Meaning of Investment

Investment is used primarily in two senses: financial sense and economic sense. In a financial sense,  investment means purchasing and selling bonds, gold and stocks. But in an economic sense, these activities are just transfers of ownership as such investment does not increase the aggregate income and employment of the economy. Thus, in economics, investment refers to that part of income that is devoted to the purchase of those goods which are used for future production of other goods or earning income. Such type of investment is known as a real investment.

Key Definitions

Defined By	Definitions
Keynes	“Investment means the current addition to the value of the capital equipment which has resulted from the productive activity of the period”
Edward Shapiro	“Investment is the value of that part of the economy’s output for anytime period that takes the form of the new structure, producer’s new durable equipment and change in inventories”
Dillard	“Investment is the net addition to the existing stock of real capital assets”

From the above discussion and definitions, investment is that part of income that is used to purchase capital goods that add value to the economy. It is purchasing of capital stocks that add to the national production or inventories. It is linked to different factors. With such linkage or relationship, the Investment function is determined. Such investment functions are mentioned below:

Classical View

I = f(i)

Where,

I = Investment

i= Interest rate

Keynesian View

I = f(i, MEC)

Where,

i= Interest rate

MEC = Marginal Efficiency of Capital

Types of Investment

There are many types of Investment in the Economy. That helps the country to grow its economy. Some key types of investment have been discussed below:

1. Autonomous Investment

Autonomous Investment is also known as government investment. it refers to the investment in houses, roads, public buildings and other parts of public infrastructure that will be utilized by the public. It does not depend on income because the government has to invest in infrastructure, roads etc.

2. Induced Investment

Induced Investment means the investment which depends on the income level of the people when the income increases then Entrepreneurs start to invest more. When the income level starts to decrease then Entrepreneurs start investing less.

3. Business Fixed Investment

Business Fixed Investment means When the Businesspeople of the country start to invest in machines, tools and equipment to increase productivity and further production of the products or goods. This kind of investment increase the value of the company.

4. Residential Investment

Residential Investment means the investment which people spend on constructing or buying new houses or to stay or rent out to others. Residential Investments help the economy to grow from three to five percent of GDP (it also depends on the economic conditions of the country.) The residential investment has good value at both the market Primary and Secondary markets.

5. Financial Investment

Financial Investment means buying new shares, bonds, or debentures that will be considered as a financial investment. the buying of old bonds, shares, or debentures will not be considered a financial investment. the financial investment directly impacts the growth of the economy.

6. Planned Investment

Planned Investment means when the investor invests money to calculate every aspect of the investment, which is called planned investment. Most of the time, the planned investment gives positive results to the investors and it also helps the investors to make faith in the company.

Determinants of Investment

There are different factors determining the level of investment in an economy. Such determinants determine the volume as well as the preference of investment. Some key determinants of investment have been discussed below:

1. Expected Rate of Return on Investment:  Investment is a sacrifice, which involves taking risks. This means that businesses, entrepreneurs and capital owners will require a return on their investment to cover this risk and earn a reward. In terms of the whole economy, the amount of business profits is a good indication of the potential reward for investment.
2. Changes in National Income: Changes in national income create an accelerator effect. Economic theory suggests that, at the macro-economic level, small changes in national income can trigger much larger changes in investment levels.
3. Interest  Rate: Investment is inversely related to interest rates, which are the cost of borrowing and the reward to lending. Investment is inversely related to interest rates for two main reasons. Firstly, if interest rates rise, the opportunity cost of investment rises. Secondly, if interest rates rise, firms may anticipate that consumers will reduce their spending and the benefit of investing will be lost.
4. The Level of Savings: Household and corporate savings provide a flow of funds into the financial sector, which means that funds are available for investment. Increased saving may reduce interest rates and stimulate corporate borrowing and investment.
5. Business Confidence:  Changes in business confidence can have a considerable influence on investment decisions. Uncertainty about the future can reduce confidence and means that firms may postpone their investment decisions until confidence returns.
6. General Expectations: Since investment is a high-risk activity, general expectations about the future will influence a firm’s investment appraisal and eventual decision-making. Any indication of a downturn in the economy, a possible change of government, war, or a rise in oil or other commodity prices may reduce the expected benefit or increase the expected cost of investment.
7. Corporation Tax:   Firms pay corporation tax on their profits, so a reduction in tax increases the profits they retain after tax is paid and this acts as an incentive to invest.

Marginal Efficiency of Capital (MEC)

Marginal Efficiency of Capital (MEC) is an important concept in investment and investment decision-making. This concept was introduced by J.M. Keynes. Marginal efficiency of capital in the ordinary sense means the expected rate of profit. It is the expected rate of return over cost or the expected profitability of a capital asset.

The marginal efficiency of a given capital asset is the highest rate of return over the cost expected from an additional or marginal unit of that capital asset. In this regard,  the marginal efficiency of capital depends upon two factors: (1) the prospective yield from the capital asset and (2) the supply price of this asset (which is the source of prospective yield).

The Prospective Yield

The term “prospective yield” refers to the amount of annual income an investor expects to obtain from selling the output of his investment or capital assets after deducting the running expenses for obtaining that output during its lifetime. In other words, the prospective yield of a capital asset is the aggregate net return expected from it during its lifetime.

If we divide this total expected life of a capital asset, say a factory, into a series of periods, usually years, we may refer to the annual returns as a series of annuities, represented by Q₁, Q₂, Q₃…. Q_n, the subscripts referring to the years of respective annuities. This series of annuities (that is, the returns accruing once every year) is conveniently called the “prospective yield of an investment.”

The Supply Price

It should be noted that the supply price of a particular type of asset is the cost of producing a new asset of that kind and not the price of the existing asset of that kind. Thus, the supply price of an asset is alternatively called “replacement cost”.

Keynesian Approach

By relating these two concepts, the prospective yields and the supply price, Keynes arrives at a precise definition of the marginal efficiency  of capital as “being equal to that rate of discount which would make the present value of the series of annuities given by the return expected from the capital asset during its life just equal to its supply.” In other words, the marginal efficiency of a capital asset is the rate at which the prospective yield expected from one additional unit (marginal unit) of the asset must be discounted if it is just equal to the cost, that is, the supply price of that asset. The discussed relationship can be expressed in the following terms:

Sp = Q₁/(1 +e) + Q₂/(1+e)² + ….+ Q_n/(1+e)ⁿ

Where SP is the supply price of the capital asset. It is the cost of constructing a new capital asset or the price which is to be paid for purchasing the new asset. Q₁, Q₂, Q₃–Q_n are a series of anticipated annual returns of the prospective yields of the capital assets in the years 1,2,3,.. n, respectively and e is the rate of discount or the marginal efficiency of capital. It should, however, be remembered that the value of Q tends to vary each year in a dynamic economy. Hence, we may find some typical discount rate or marginal efficiency of capital e, which will equalize the two sides of the equation.

The term, Q₁/ (1 +e) a represents the current value of the annuity or yield receivable at the end of the first year discounted at the rate (e). If the rate of discount is assumed to be 10 percent, each rupee (that is, 100 paisa) which we expect to get after a year, is worth 90.91 paisa now.