Investment – definition and explanation

Definition of investment: Investment is the addition to 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
  • 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:
    •  Physical Capital e.g. machines or
    •  Human Capital e.g better education to increase labour productivity

Marginal Efficiency of Capital (MEC)


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 2 reasons:

1. The rate of interest shows the cost of borrowing money to fund investment
2. 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.

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

2. Technological change,
If new technology is invented firms will want to invest more.

3. Expectations and business confidence.
Keynes believed this was very important. Keynes termed it “animal spirits”

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


Loanable Funds Theory


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
  • 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 the loanable fund will cause a shortage of funds this will cause interest rates to rise and therefore this will encourage an increase in saving.

Autonomous Investment

Autonomous Investment is the level of investment independent of national output. This will include Government investment, investment to replace worn-out capital and any other type of investment that is not dependent on changes in GDP.

Induced investment

Induced investment is the level of investment related to demand and expectations of demand. This induced investment will be highly cyclical and will respond to changes in the rate of economic growth

The accelerator theory

The accelerator theory suggests that investment is highly volatile and related to the rate of economic growth. Therefore induced investment is highly volatile, but its volatility is reduced by the significant role played by autonomous investment.



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