Scribd
Upload
370 views18 pages

Investment Function

This document discusses investment functions and determinants of investment according to Keynesian economics. It defines investment as additions to a country's existing capital stock, such as new buildings, machinery, and infrastructure projects. Investment can be autonomous, which does not change with income levels, or induced, which increases as income rises. The marginal efficiency of capital (MEC) and interest rates are the two main determinants of investment - investment occurs when MEC is greater than the interest rate. The schedule of MEC shows a negative relationship between MEC and investment levels.

Uploaded by

Sana Zahid
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
370 views18 pages

Investment Function

This document discusses investment functions and determinants of investment according to Keynesian economics. It defines investment as additions to a country's existing capital stock, such as new buildings, machinery, and infrastructure projects. Investment can be autonomous, which does not change with income levels, or induced, which increases as income rises. The marginal efficiency of capital (MEC) and interest rates are the two main determinants of investment - investment occurs when MEC is greater than the interest rate. The schedule of MEC shows a negative relationship between MEC and investment levels.

Uploaded by

Sana Zahid
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 18

INVESTMENT FUNCTION

MEANING OF INVESTMENT:

ADDITION TO THE EXISTING STOCK OF CAPITAL ASSETS IN A COUNTRY IS KNOWN AS INVESTMENT.


• EXAMPLES:
 CONSTRUCTION OF NEW BUILDINGS
 ADDITION OF NEW MACHINERY
 NEW MEANS OF TRANSPORT & COMMUNICATION
 ISSUANCE OF NEW SHARES AND BONDS
 NEW PUBLIC WORKS PROGRAMS
 NET FOREIGN INVESTMENT
INVESTMENT FUNCTION:

• IT REPRESENTS DIFFERENT AMOUNTS OF INVESTMENT AT DIFFERENT LEVELS OF


INCOME.
• THEREFORE, THIS CURVE IS ALSO KNOWN AS THE SCHEDULE OF PROPENSITY TO
INVEST.
• TWO TYPES ARE AS FOLLOWS:
i. AUTONOMOUS INVESTMENT
ii. INDUCED INVESTMENT
AUTONOMOUS INVESTMENT

• THE INVESTMENT WHICH DOES NOT CHANGE WITH THE CHANGE IN THE LEVEL OF
NATIONAL INCOME, IS KNOWN AS AUTONOMOUS INVESTMENT.
• IT REMAINS THE SAME.
• INCOME INELASTIC INVESTMENT.
• THIS TYPE OF INVESTMENT IS GENERALLY MADE BY THE GOVT DISREGARDING
THE PROFIT
AND ITS MAIN OBJECTIVE IS TO MAXIMIZE THE SOCIAL BENEFIT.
• THIS TYPE OF INVESTMENT INCLUDES LONG TERM PROJECTS TO ENABLE THE
ECONOMY
TO TAKE OFF.
AUTONOMOUS
Income Investment
INVESTMENT SCHEDULE:
(Rs. billion) (Rs. billion)

100 20

200 20

300 20

400 20

500 20
CHANGES IN AUTONOMOUS
INVESTMENT:
• CHANGE IN THE PRODUCTION TECHNOLOGY
• GOVT INTRODUCES DRASTIC CHANGES IN THE MONETARY AND
FISCAL POLICY
INDUCED INVESTMENT
Income Investment
• THE CHANGE IN INVESTMENT
(Rs. billion) (Rs. billion)
WHICH IS INDUCED BY THE
CHANGE IN NATIONAL 100 20
INCOME IS KNOWN AS
200 40
INDUCED INVESTMENT.
300 60
• E.G., WHEN THE INCOME
LEVEL GOES UP, INVESTMENT 400 80
ALSO GOES UP AND VICE 500 100
VERSA.
CHANGES IN INDUCED INVESTMENT:
• RATE OF INTEREST
IF RATE OF INTEREST FALLS, THIS RESULTS IN A RISE IN THE
INVESTMENT LEVEL AND THE INVESTMENT FUNCTION WOULD
SHIFTS UPWARDS TO THE LEFT AND VICE VERSA.
DETERMINANTS OF INVESTMENT:

• ACCORDING TO KEYNES, THERE ARE TWO DETERMINANTS OF INVESTMENT.


i. EXPECTED RATE ON RETURN OR MARGINAL EFFICIENCY OF CAPITAL (MEC)
ii. RATE OF INTEREST
• KEYNES SAYS THAT PEOPLE MAKE INVESTMENT AS LONG AS MEC > RATE OF
INTEREST.
• IF RATE OF RETURN OR MEC FALLS BELOW THE RATE OF INTEREST WILL BE MADE.
• EXAMPLE:
SUPPOSE THAT IN A BUSINESS, AN ENTREPRENEUR INVESTS IN ADDITIONAL
MACHINERY BY BORROWING RS. 10,000 FROM A BANK AT 5% RATE OF INTEREST.
THIS WOULD CLEARLY MEAN THAT THE ENTREPRENEUR IS EXPECTING MORE THAN
5% AS PROFIT FROM THE SALE OF GOODS PRODUCED BY THE ADDITIONAL OR
MARGINAL CAPITAL ASSET.
SUPPOSE THAT THE EXPECTED RATE OF PROFIT IS 7%, HE WOULD MAKE THE
INVESTMENT BECAUSE HIS TOTAL PROFIT WOULD BE 7/100 X 10,000 = 700 AND THE
COST OF INVESTMENT AT 5% RATE OF INTEREST WOULD BE 5/100 X 10,000 = 500.
THUS, HIS NET PROFIT WOULD BE 700 – 500 = 200
NOW SUPPOSING THAT HIS PROFIT EXPECTATION PROVES TO BE WRONG AND IT
TURNS OUT THAT HIS RATE OF RETURN IS 3%, HENCE, HIS RETURN WOULD BE 3/100 X
10,000 = 300 AND THUS HIS NET LOSS WOULD BE 300 – 500 = -200
MARGINAL EFFICIENCY OF CAPITAL
(MEC):
• “THE HIGHEST RATE OF RETURN OVER COST EXPECTED FROM
APPLICATION OF A MARGINAL UNIT OF THE CAPITAL ASSET”.
• THE DEFINITION EXPLAINS THE RELATIONSHIP BETWEEN TWO
VARIABLES, I.E., EXPECTED RATE OF RETURN AND THE COST OF
CAPITAL ASSET (ALSO KNOWN AS SUPPLY PRICES).
• THUS, MEC IS THE RATIO BETWEEN THE PROSPECTIVE ANNUAL
YIELD OF ADDITIONAL (MARGINAL) CAPITAL ASSET AND ITS
SUPPLY PRICE.
• ASSUMING THAT THE LIFE OF THE CAPITAL ASSET IS ONE YEAR,
THEN THE MEC WILL BE CALCULATED BY THE RATIO BETWEEN
THE PROSPECTIVE ANNUAL YIELD OF THE MARGINAL CAPITAL
ASSET AND ITS SUPPLY PRICE (OR THE COST OF THE MARGINAL
CAPITAL ASSET).
Supply Price of Marginal Prospective Annual MEC(%)= Prospective
Capital Asset Yield Annual Yield/ Supply price X
100
1,000 100 10
1,000 70 7
4,000 160 4
8,000 160 2

• KEYNES SAYS THAT THERE IS ALWAYS A SECULAR DECLINE IN THE MEC OVER A LONG PERIOD OF TIME. THIS OCCURS AS
RESULT OF TWO FACTORS:

1. PROSPECTIVE ANNUAL YIELDS MAY GO DOWN WITH THE PASSAGE OF TIME, E.G., THE FIRST TWO ROWS SHOWS THAT THE
SUPPLY PRICE REMAIN THE SAME BUT PROSPECTIVE ANNUAL YIELD GOES DOWN AND THEREFORE MEC FALLS. THIS OCCURS
AS A RESULT OF THE ENTRY OF NEW FIRMS IN THE INDUSTRY DUE TO WHICH SUPPLY OF GOODS AND SERVICES MAY INCREASE
AND CONSEQUENTLY PRICE OF THE PRODUCT MAY FALL. THIS RESULTS PROSPECTIVE ANNUAL YIELD TO FALL.

2. THE SECOND FACTOR IS THAT THE SUPPLY PRICE MAY INCREASE OVER TIME, E.G., THE LAST TWO ROWS IN THE FIRST COLUMN
SHOW THAT THE SUPPLY PRICE INCREASED FROM 4000 TO 8000 WHILE THE PROSPECTIVE YIELD REMAINS CONSTANT AT 160
AND CONSEQUENTLY MEC FALLS FROM 4% TO 2%. THIS FACTOR OCCURS AS A RESULT OF THE ENTRY OF NEW FIRMS IN THE
INDUSTRY DUE TO WHICH DEMAND FOR THE CAPITAL ASSETS INCREASES AND A RESULT THEIR SUPPLY PRICE INCREASES.
• HOWEVER, IF THE LIFE OF CAPITAL ASSET IS ONE YEAR, MEC WILL BE CALCULATED IN ACCORDANCE WITH THE
DEFINITION OF MEC AS GIVEN BY KEYNES.

• THE DEFINITION EXPRESSES THAT:

• SUPPLY PRICE = PROSPECTIVE ANNUAL YIELD DISCOUNTED BY MEC OVER THE LIFE TIME OF A CAPITAL ASSET.

• SP* = Y1 + Y2 + Y3 + ... + YN

(1+E)1 (1+E)2 (1+E)3 (1+E)N

• SP = SUPPLY PRICE

• Y = PROSPECTIVE ANNUAL YIELD IN THE 1ST, 2ND, 3RD AND NTH YEAR

• E = MEC OR RATE OF DISCOUNT

• EXAMPLE:

• SP = 900

• LIFE OF CAPITAL ASSET IS 2 YEARS

• AT THE END OF FIRST AND SECOND YEAR, THE ENTREPRENEUR GETS RS.440 AND 605 RESPECTIVELY.

• ASSUME MEC= 10%

• 900 = 440/(1+ 10/100) + 605/(1+ 10/100)2

• 900 = 400 + 500

• 900 = 900

• THUS, DISCOUNTED ANNUAL YIELD = SP OF CAPITAL ASSET AND THEREFORE MEC IS 10%
SCHEDULE OF MEC:
• IT IS THE CURVE REPRESENTING DIFFERENT
RATES OF MEC AT DIFFERENT LEVELS OF
INVESTMENT IN THE MARGINAL UNITS OF
CAPITAL ASSET.
• NEGATIVE RELATIONSHIP BETWEEN MEC
AND THE AMOUNT OF INVESTMENT.
• REASONS:
i. WITH AN INCREASE IN INVESTMENT, THE
DEMAND FOR CAPITAL ASSET RISES DUE TO
WHICH ITS RESULT IN THEIR SUPPLY PRICE
TO RISE AS WELL. HENCE, MEC FALLS.
ii. THE OUTPUT PRODUCED BY NEW CAPITAL
ASSETS COMPETES WITH THE OUTPUT
PRODUCED BY THE OLD CAPITAL ASSETS.
HENCE, PRICE OF THE PRODUCT FALLS AND
SO DOES THE MEC.
RISE AND FALL OF MEC:
• ME CURVE SHOWS THAT INVESTMENTS ARE ONLY MADE WHEN MEC > R
• THE LEVEL OF INVESTMENT WILL CONTINUE TO INCREASE UNTIL THE POINT
WHERE MEC = R
• WHEN R IS 7% WITH A INVESTMENT OF RS. 5 BILLION IS MADE AS MEC IS
ALSO 7%. THIS IS SHOWN BY POINT R..
• WHEN R FALLS TO 4%, IT RESULT AS INCREASE IN INVESTMENT TO RS.7
BILLION.
• AN INCREASE IN INVESTMENT LEVEL OCCURS BECAUSE MEC > R.
• THE INVESTMENT LEVEL STOPS HERE AS MEC LEVEL ALSO FALLS DOWN TO
4% WITH THE PASSAGE OF TIME. THIS IS SHOWN BY THE POINT W.
• A RISE IN MEC OCCURS AS A RESULT OF BRIGHT PROFIT PROSPECTS AND
VICE VERSA.
• BOOM AND DEPRESSION: DURING BOOM, THE GENERAL PRICE LEVEL
HAS THE TENDENCY TO GO UP, BECAUSE PEOPLE ARE OPTIMISTIC
ABOUT THE FUTURE AND AS A RESULT THE MEC RISES AND THE
INVESTMENT LEVEL ALSO INCREASES. FOR THE DEPRESSION PERIOD,
THE SITUATION WOULD BE JUST THE OPPOSITE.
• CHANGE IN THE RATE OF TAXES: AN INCREASE IN THE TAX RATE
RESULTS IN THE COST OF PRODUCTION GOING UP AND MEC FALLS.
CONSEQUENTLY, WHEN THE TAX RATE IS REDUCED THE COST OF
PRODUCTION GOES DOWN WHICH RESULTS IN THE PROFIT PROSPECTS
TO INCREASE AND HENCE THE MEC RISES.
• GROWTH OF POPULATION: AN INCREASE IN POPULATION RESULTS IN
AN INCREASE IN THE DEMAND FOR COMMODITIES DUE TO WHICH
PRICES RISE AND AS A RESULT THE MEC RISES.
RATE OF INTEREST:
• ACCORDING TO KEYNES, THE TWO DETERMINANTS OF INVESTMENT ARE:
i. MEC
ii. RATE OF INTEREST
THERE ARE TWO DETERMINANTS OF RATE OF INTEREST.
iii. LIQUIDITY PREFERENCE (DEMAND FOR MONEY)
iv. QUANTITY OF MONEY (SUPPLY OF MONEY)
• THE LP SHOWS A NEGATIVE RELATIONSHIP WITH THE RATE OF INTEREST
WHILE THE SUPPLY OF MONEY HAS A POSITIVE RELATIONSHIP WITH THE
INTEREST RATE.
• THE EQUALITY BETWEEN THESE TWO FUNCTIONS DETERMINES THE
EQUILIBRIUM RATE OF INTEREST.
LIQUIDITY PREFERENCE:
i. TRANSACTION MOTIVE
ii. PRECAUTIONARY MOTIVE
iii. SPECULATIVE MOTIVE

QUANTITY OF MONEY:
THE SUPPLY OF MONEY WOULD COME FROM THE PAPER
MONEY, METALLIC /COINS MONEY AND CREDIT MONEY.
KEYNES ASSUMES THAT IN THE SHORT PERIOD THE SUPPLY
OF MONEY REMAINS CONSTANT.

You might also like