INVESTMENT FUNCTION

Meaning of Investment

In Ordinary sense, investment means to buy shares, stocks, bonds and securities which are already existing in stock market. But, this is not real investment because it is simply a transfer of existing assets. Hence, this is called financial investment which does not affect aggregate spending. In Keynesian terminology, investment refers to real investment which adds to capital equipment increasing the production and purchase of capital goods. Thus, investment includes new plant and equipment, construction public works like dams, roads, buildings, etc. net foreign investment, inventories, and stocks and shares of new companies. In the words of Joan Robinson, “By investment is meant an addition to capital, such as occurs when a new house is built. Investment means making or a new factory is built. Investment means making an addition to the stock of goods in existence.”

Keynes again states that real investment means purchase of equities, bonds or securities of the companies to be newly set up. It means “addition to the existing stock of real capital assets”. The essential condition is that investment should result in the construction of new capital assets, necessitating the employment of more labour and raw material.

Investment function is related to private or induced investment. It implies inducement to invest or investment demand. For classical economists, investment demand was simply a decreasing function of rate of interest. I.e.,

 

I = f (i)

Where,    i =rate of interest

and         I = investment

It can be shown in figure below;

In this figure, Id Id is investment demand curve. Rate of interest is measured along on OY-axis and investment on OX-axis. Id Id curve shows that there is inverse relationship between rate of interest and investment. Thus, investment is the function of rate of interest.

According to Keynes, the volume of private investment depends upon two factors;

(i)   The marginal efficiency of capital (MEC) and

(ii) The rate of interest (i)

Thus,      I = f (r,i)

Where,    r = MEC

However, in the modern theory, the investment is assumed to be the function of level of income. Other things remaining the same investment is the direct function of level of income. I.e.,

I= f (Y)

Where,    Y= Level of income.

As income increases, the investments will also increases and vice-versa. This modern investment function is shown in the following diagram.

In the given figure, at Y1 level of income, investment is I1. When the level of income increases from Y1 to y2, investment increases from I1 to I2. It means that investment varies positively with the level of income. Thus, investment is the function of income.

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