The definition of investment is spending on goods and materials which increase the capital stock of the economy- e.g. factories, machines, or any item that is used to produce other goods and services.
· Note saving money in a bank is not investment in economic terminology. When we save money, there is no increase in the capital stock. (see: difference between saving and investment)
Gross and Net Investment
- The value of capital stock depreciates over time as it wears out and is used up, this is called depreciation.
- Gross investment measures investment before depreciation.
- Net Investment measures gross investment less depreciation
Depreciation accounts for ¾ of gross investment
· Investment can be in either:
- i) Physical Capital e.g. machines or new buildings.
- ii) Human Capital e.g better education to increase labour productivity
Investment can also be created by the private sector or public sector.
Marginal Efficiency of Capital
The rate of return for an investment project is known as the marginal efficiency of capital.
The cost of capital or investment is related to the rate of interest for two reasons:
- The rate of interest shows the cost of borrowing money to fund investment. Higher interest rates make investment less attractive. A cut in interest rates from R1 to R2 will increase investment to I2.
- The alternative to investing is saving money in a bank, this is the opportunity cost of investment.
If the rate of interest is 5% then only projects with a rate of return of greater than 5% will be profitable.
If interest rates fall to 3%, more investment projects will be profitable.
Factors which shift the Planned Investment schedule
1. A change in the cost of capital,
E.g. an increase in the cost of capital will lead to a fall in investment. A shift from MEC 2 to MEC1
2. Technological change,
If new technology is invented firms will want to invest more because investment becomes more profitable.
3. Expectations and business confidence.
Keynes believed this was very important. Keynes termed it “animal spirits”. Rising confidence will encourage people to invest more - whatever the rate of interest.
4. Government Policy.
E.g. the govt could have tax breaks for firms to increase investment
5. Supply of finance.
If banks are more willing to lend money investment will be easier.
more on marginal efficiency of capital
Loanable Funds Theory
The theory of lonable funds states that in an economy, the interest rate will be determined by the supply of finance (loanable funds) and the demand for loanable funds
- The supply of finance is the level of savings in the economy.
- When people deposit money in banks these funds can be lent out to firms for investment in physical capital.
- Higher interest rates will encourage people to save more and discourage investment
- Saving will also be dependent upon incomes and confidence a change in these could shift the supply curve.
A shift in the supply or demand curve will cause a change in the level of interest rate
An increase in demand for loanable funds will cause a shortage of funds; this will cause interest rates to rise and therefore this will encourage an increase in saving.
- Investment Levels in UK data and importance of investment.