1.

Introduction

Investment in simple words is the purchase of stocks, bonds, plant and machinery,
buildings etc. The investment which does not generate any output and is a mere transfer
of ownership, is called financial investment. Therefore, financial investment in shares is
not included in the economic definition of investment. The real investment on the other
hand adds to the capital stock and creates productive capacity. It leads to an increase in
the level of income, employment and production by raising the stock of goods. Apart
from financial and real investment, there are other basis also to distinguish between
different types of investments. The level of investment in the economy is sensitive to
changes in the prevailing interest rate. Generally, when interest rates are high, investment
decreases and vice-versa.
The Keynesian theory of investment gives importance to the role of interest rates in
investment decisions. Changes in interest rates affect the level of planned investment
undertaken in the economy. A fall in interest rates decreases the cost of investment
relative to the potential yield and as a result planned capital investment projects on the
margin become worthwhile and investment rises. A firm will only invest if the discounted
yield exceeds the cost of the project. The inverse relationship between the investment and
the rate of interest is represented by the marginal efficiency of capital investment (MEC)
curve. Not just the rate of interest but other factors also affect the expected profitability of
an investment project like, expectations, costs, technical change, etc.
Let us analyse in detail the meaning, different types and determinants of investment
spending.

2. Investment

Investment is an increase in the capital stock such as buying a factory or machine or in

simple words it is the addition to the productive capacity. The decision of firms and
individuals about how much investment to make depends on interest rates and marginal
efficiency of capital. If interest rates are high then it makes it expensive to borrow money
and leads to a fall in investment. This is because investment is often financed through
borrowing. Also, when interest rates are high it becomes more attractive to save money.
Investment is often financed out of retained profit. Thus, high interest rate means that
saving money in a bank is more attractive than investment. Marginal efficiency of capital
in simple words is the expected profit rate from investment.
The investment decision is a marginal benefit-marginal cost decision, where the marginal
cost is the interest rate (i) that must be paid for borrowed funds and marginal benefit
derived from investment is the expected rate of return (r). Any investment decision will
be made by comparing these cost and benefit. An investment is made if the expected rate
of return exceeds the interest rate (r > i). Investments are not made when interest rate
exceeds the expected rate of return (r < i). When the marginal benefit is exactly equal to
marginal cost, then this will be an individual’s decision to invest or not according to the
need.
Fig 1 Investment Function

Investment is inversely related to interest rate as shown by the downward sloping

investment curve. Any change in rate of interest will lead to a movement along the
investment curve raising or lowering it. If there is a change in any other factor apart from
interest rate like, cost, expectations, technology etc, this will lead to shift in the
investment demand curve.

3. Investment - Types

There are many basis on which investment can be distinguished:

Planned Investment and Unplanned investment

The planned or intended or voluntary investment is undertaken by a firm in order to
achieve certain predefined targets. It leads to an increase the existing stock of capital
through addition to inventories or installation of an additional machine. This type of
investment may be motivated by larger sales or by favourable market conditions.
The unplanned or unintended or involuntary investment on the other hand is that part of
investment which is not anticipated or intended by the firm. It takes place when the
planning does not go well with the real world situations.
When the unplanned investment is equal to zero, the realised investment will be equal to
the planned investment. But the actual or the realised investment may not be equal to the
planned investment. So, the realised investment is equal to the sum of planned and
unplanned investment. Thus,
Actual investment = Planned investment + Unplanned investment

Financial Investment and Real Investment

The financial investment can be in the form of deposits into the bank, purchase of
existing shares, debentures, bonds in the secondary market, etc. All such investments lead
to the transfer of ownership rights from one person to another and do not create anything
new. It does not add to the real capital stock in the economy. From the economy point of
view there is no investment as these leave the stock of economy’s real capital unchanged.

The real investment on the other hand leads to the creation of additional productive
capacity in the economy. The examples of real investment include, establishment of a
new factory on a workshop, acquisition of new plant & machinery, purchase of a new
building for official or personal use. Real investment has significance for the economy
also as this raises the capital stock and in turn the income. It is important to note that
when individual purchases new shares of a company, this financial investment will
represent the real investment, because that would create a new capital asset.

Gross Investment and Net Investment

The gross investment is whatever additions are made to the capital stock of the economy.
This can take the form of expenditure on new fixed capital assets (e.g. houses, machinery,
factories etc.) or change in inventories over a given period of time. However, a part of the
new capital is used to replace the depreciated capital goods, so the gross investment is not
the net addition to the capital stock. The expenditure that a firm incurs to replace the
depreciated capital during the year is called the replacement investment.
The net investment is obtained after deducting this replacement investment from the
gross investment.

Thus, Net investment = Gross investment – Replacement investment

Or Gross investment = Net investment + Replacement investment

Autonomous Investment and Induced Investment

This classification of investment is based on the determinants of investment. The
investment is said to be autonomous if the amount of investment is unaffected by the
level of income or the market rate of interest. This investment depends upon certain
socio-economic and political factors.
On the other hand, investment that depends upon the profit or income expectations of the
entrepreneurs is called the induced investment. There can be many factors like prices,
wages and interest changes which affect profits and thereby induce the investment level
in the economy. An increase in the level of income causes an increase in the level of
employment and thus an increased demand for the consumer goods. This, in turn leads to
an increase in investment. While the investment is inversely related to the rate of interest.
This is because interest rate is the cost of investment, higher interest rates, discourages
investment.

4. Determinants of Investment

Investment and production decisions are taken by the firms by considering their
profitability. These decisions are influenced by the expectations that entrepreneurs form
about future revenue and cost streams which allow them to make guesses about what
their profits might be. Investment decisions thus depend on whether the productive asset
being purchased delivers a positive return above the cost.
There are two main determinants which influence the decision of a firm or individual to
invest in a new project:

1. The Market Rate of Interest

Whenever an entrepreneur decides to invest in a capital good, he either borrows funds
from the market for which he has to pay the market rate of interest or uses his own
resources to finance the investment for which he sacrifices the interest rate which he
could have earned on by lending his funds. So, the rate of interest is the price of
investment. A higher price in the form of high interest rate will discourage investment.
2. The Marginal Efficiency of Capital
The marginal efficiency of capital is a technical ratio which tells by how much investing
in capital increases output. It can also be considered as the expected rate of return on
capital investment. Specifically it refers to the annual percentage yield earned by the last
additional unit of capital. The investment decisions are based on the comparison of MEC
with the market rate of interest. If the marginal efficiency of capital was 5% and interest
rates were 3%, then it is worth borrowing at 3% to get an expected increase in output of
5%. However, if the marginal efficiency of capital is less than interest rates it is not worth
investing. Marginal efficiency of capital is in turn determined by two factors:
i) The Supply Price of Capital Asset
The supply price of an asset is the price at which a capital asset is acquired. This purchase
price of the asset is called as supply price or the replacement cost by Keynes. At this
price new capital asset is supplied or purchased.

ii) Prospective Yield of the Investment/ Capital Asset

Prospective yield is the expected flow of income from the investment during its lifetime.
It is calculated by deducting the supply price of the capital asset from the expected
income from the use of the asset during its working lifetime. Whenever a capital asset is
purchased, its total working life and its return remain uncertain. Therefore, the
entrepreneur has to make a careful estimate of the expected life of capital asset as well as
the flow of income during its lifetime. As the capital asset is expected to be used for a
number of years, its annual return in each period is added to get the return during its
economic life. This annual net return expected from an asset is termed as ‘annuity’.
Present value of these annuities is obtained by discounting each annuity for the number of
years it is expected to be used from the present. The discount rate used is the expected
yield from the asset and it is calculated by doing compound interest calculations in
reverse.
So, prospective yield is a “series of annuities let us say Q1, Q2, … Qn”. These are future
flows of cash associated with an investment which the entrepreneur “expects to obtain
from selling its output”. The current value of a future cash flow is called its present
value (PV). The general formula for present value of a cash flow to be received at the end
of period n is:
Pt = Pt+n /(1 + i)n
Where Pt can be thought of as the purchase price, P t+n can be considered as the net future
yield on the asset n years from now and i is the rate of discount or yield rate.

In the situation where the expected cash flows of varying size are distributed across
several different time periods, the present value of a flow at time t, Pt can be written as:

Pt = Pt+1/(1 + i) + Pt+2/(1 + i)2 + Pt+3/(1 + i)3 + … + Pt+n/(1 + i)n

In this equation Pt is the total discounted present value of the future streams of incomes
expected from the investment in the capital good during its lifetime. The terms on the
right hand side of the equation represent the present value of the expected income flow
expected at the end of each year.
Firms are faced with different investment options with different revenue and cost outlay
profiles over time. So, a firm should undertake an investment project only is the cost of a
capital asset is less than the total present value of the prospective yield. If the cost of the
asset exceeds the present value of the yields, then it is worthless to undertake investment.
5. Marginal Efficiency of Capital (MEC)

Keynes defined 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 returns
expected from the capital-asset during its life just equal to its supply price. The rate of
discount he was referring to is also known as the internal rate of return of a project. The
internal rate of return is the interest rate that would discount future income and cost
outlays such that the net present value was zero.
We can calculate the present value of a capital asset by discounting the value of its future
flows. The net present value is the present value of the revenue to be received minus the
present value of the costs of the capital investment.
A positive net present value implies that investment earns a positive rate of return while a
negative present value means that the investment is worthless.
Consider the investment on an equipment which is expected to be used for 5 years. In the
current year, the firm has to spend $10,000 to purchase the equipment. In subsequent
years it receives the cash flows of $2,500, $3,200, $3,500, $3,300 and $2,400,
respectively. If there is no scrap value for the equipment after year 5, what will be the
internal rate of return of this investment?
The present value of the cost is $10,000 incurred in the current year. If we add up the
cash flows in each of these years, the dollar sum of the cash returns turn out to be
$15,000. But the dollar amounts cannot be compared across time periods because of the
impact of compounding.
The present value of the flow of revenue is given by:
PV = $2,500/(1 + i) + $3,200/(1 + i)2 + $3,500/(1 + i)3 + $3,300/(1 + i)4 + $2,400//(1 + i)5
The internal rate of return is the discount rate (i)) that satisfies the following equation:
NPV = + $2,500/(1 + i) + $3,200/(1 + i)2 + $3,500/(1 + i)3 + $3,300/(1 + i)4 + $2,400//(1
+ i)5 - $10,000 = 0
Mathematically solving the above equation, we calculated the IRR at 15.1 per cent.
This investment will be profitable if the cost of borrowing funds to fund the project (that
is, the market rate of interest) is below the IRR.

Internal rate of return is nothing but the marginal efficiency of capital that we compare
with the market rate of interest to decide the viability and profitability of any investment
project. The market rate of interest remains almost stable but MEC is volatile. Firms seek
to invest in those projects which yield higher MEC. MEC schedule relates MEC to
alternative levels of investment of a firm.
Suppose there are three investment projects A, B and C available with the firm with
different MEC. Project A has an IRR (or MEC) of 10 per cent, while Project B has an
MEC of 8 per cent and Project C has an MEC of 5 per cent.
The firm must consider how much new capital expenditure it will incur for the coming
year on the basis of the profitability of each investment project. If the market rate of
interest is currently 9 per cent, then the firm would only be interested in investing in
Project A, which means that its capital expenditure in the current planning period will be
limited to Project A.
If the market interest rate drops to below 8 per cent, then it will be profitable to borrow
sufficient funds (or use retained earnings) and invest in both Project A and Project B. As
a consequence total investment will rise. The firm will expand investment to Project C if
the market rate of interest drops below 5 per cent.
The downward sloping MEC curve shown in Fig 2 shows the inverse relation between
Investment and MEC.

Fig 2 MEC curve

There is an inverse relation between MEC and investment because:

(a) More investment leads to higher output, this will intensify competition among the
producers driving down the prices. As prices fall, prospective yield from capital asset
declines.
(b) Increase in investment raises the price of capital assets, this means that the supply
price of capital assets rises, consequently MEC falls.

Shifts in the marginal efficiency of capital

Any change in MEC leads to a movement along the MEC curve but we should also
consider the crucial role of expectations and other factors firms might consider when
forming expectations of future returns.

If the planned investment changes at a given rate of interest, this causes a shift in the
MEC curve. For example, a rise in the expected rates of return on investment projects
would cause an outward and rightward shift in the marginal efficiency of capital curve.
This is shown by a shift from MEC to MEC1 in Fig 3.
Fig 3 Shift in MEC curve

Conversely, if pessimism prevails, a fall in business confidence would cause a fall in

expected rates of return on capital investment projects. The MEC curve shifts to the left
and causes a fall in planned investment at each rate of interest.

6. MEC and Rate of Interest

The simple investment model, which says that higher market rate of interest leads to
lower total investment is based on the assumption that all other things are equal. But
MEC plays an important role in determining the investment. It is based on the
comparison between the demand-side (expected revenue) and the supply-side (the
replacement cost).
In a growing economy, the analysis of investment only on the basis of interest rate could
be misleading. It is possible that at times aggregate demand conditions are improving
even when the market rate of interest rises. The increased aggregate demand will improve
the revenue cash flows over time and increase the MEC for each project. This implies
that investment will not fall even when the market rate of interest is high because the IRR
or MEC of each project is increasing.

Thus investment would not be very responsive to changes in the market rate of interest,
especially when the economy was in recession or boom, this is because expectations
formed by entrepreneurs affect their MEC calculations.
When the economy is in recession, entrepreneurs would become pessimistic and this
would negatively impact their assessment of the future returns from different projects.
Even with substantial excess productive capacity, firms are unlikely to expand the capital
stock even if new investment projects become cheaper as the central bank cuts the market
interest rate to stimulate demand.
The extreme optimism that typically accompanies a boom also would reduce the
sensitivity of investment to changes in the market rate of interest. With high expected
returns, firms will be prepared to pay higher borrowing costs.
Optimism can be shown by a rightward shift of the MEC curve, which would raise
investment at a given market rate of interest.
If entrepreneurs became excessively pessimistic then the MEC curve would shift
leftwards and fewer investment projects would be deemed profitable at a given market
rate of interest even if the technical aspects of the equipment was unchanged.
This implies that investment is a very subjective act and responsive to how firms felt
about the economy.
In short, the profitability of any investment project is assessed by comparing its MEC
with the market rate of interest. If MEC is higher than r then only any investment will be
made.

7. Summary

1. Investment is an act of addition to the productive capacity of a firm.

2. The investment decisions are based on the marginal benefit-marginal cost analysis,
where the marginal cost is the interest rate and marginal benefit is the MEC.
3. Investment can be classified in many ways like, gross and net investment, real and
financial investment, autonomous and induced investment, etc.
4. Marginal Efficiency of Capital is that rate of discount which makes the present value
of the series of annuities given by the returns expected from the capital-asset during its
life just equal to its supply price.
5. Any investment project is considered profitable only when its MEC is higher than the
prevailing market rate of interest.