An investment function is a concept or strategy within economics that helps to identify the connection between shifts in the national income and the investment patterns that take place within that particular national economy.
In this type of situation, a function would be any variable within the framework of the economy that would motivate investors to change their typical buying and selling habits as a means of either taking advantage of the economic shift in a bid to increase their returns or to minimize the amount of loss incurred as a result of that shift. In weighing variables, the investor will consider the current level of gross domestic product (GDP) as well as the average interest rates that currently apply within the economy.
The investment function is a summary of the variables that influence the levels of aggregate investments. It can be formalized as follows:
I=f(r,∆Y,q)
Types of Investment
Different types or kinds of investment are discussed in the following points.
1. Autonomous Investment
Investment which does not change with the changes in income level, is called as Autonomous or Government Investment. Autonomous Investment remains constant irrespective of income level. Which means even if the income is low, the autonomous, Investment remains the same. It refers to the investment made on houses, roads, public buildings and other parts of Infrastructure. The Government normally makes such a type of investment.
2. Induced Investment
Investment which changes with the changes in the income level, is called as Induced Investment. Induced Investment is positively related to the income level. That is, at high levels of income entrepreneurs are induced to invest more and vice-versa. At a high level of income, Consumption expenditure increases this leads to an increase in investment of capital goods, in order to produce more consumer goods.
3. Financial Investment
Investment made in buying financial instruments such as new shares, bonds, securities, etc. is considered as a Financial Investment.
However, the money used for purchasing existing financial instruments such as old bonds, old shares, etc., cannot be considered as financial investment. It is a mere transfer of a financial asset from one individual to another. In financial investment, money invested for buying of new shares and bonds as well as debentures have a positive impact on employment level, production and economic growth.
4. Real Investment
Investment made in new plant and equipment, construction of public utilities like schools, roads and railways, etc., is considered as Real Investment.
Real investment in new machine tools, plant and equipments purchased factory buildings, etc. increases employment, production and economic growth of the nation. Thus real investment has a direct impact on employment generation, economic growth, etc.
5. Planned Investment
Investment made with a plan in several sectors of the economy with specific objectives is called as Planned or Intended Investment.
Planned Investment can also be called as Intended Investment because an investor while making investment, make a concrete plan of his investment.
6. Unplanned Investment
Investment done without any planning is called as an Unplanned or Unintended Investment.
In unplanned type of investment, investors make investment randomly without making any concrete plans. Hence it can also be called as Unintended Investment. Under this type of investment, the investor may not consider the specific objectives while making an investment decision.
7. Gross Investment
Gross Investment means the total amount of money spent for creation of new capital assets like Plant and Machinery, Factory Building, etc. It is the total expenditure made on new capital assets in a period.
8. Net Investment
Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of time, usually a year.
It must be noted that a part of the investment is meant for depreciation of the capital asset or for replacing a worn-out capital asset. Hence it must be deducted to arrive at net investment.
Marginal Efficiency of Capital MEC
The Marginal efficiency of capital displays the expected rate of return from investment, in a particular given time. The marginal efficiency of capital is compared to the rate of interest.
Keynes described the marginal efficiency of capital as:
"The marginal efficiency of capital is 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." - J.M.Keynes, General Theory.
This theory suggests investment will be influenced by:
- The marginal efficiency of capital
- The interest rates
Generally, a lower interest rate makes investment relatively more attractive.
If interest rates, were 3%, then firms would need an expected rate of return of at least 3% from their investment to justify investment. If the marginal efficiency of capital was lower than the interest rate, the firm would be better off not investing, but saving the money.
Why are interest rates important for determining the Marginal efficiency of capital?
To finance investment, firms will either borrow or reduce savings. If interest rates are lower, it's cheaper to borrow or their savings give a lower return making investment relatively more attractive.