What are the basic determinants of investment explain relationship

Factors affecting investment | Economics Help

what are the basic determinants of investment explain relationship

Basic Macroeconomic Relationships economic variables, we will focus in this lesson on an explanation of the determinants of consumption and investment. Investment is expenditure on capital goods - for example, new machines, offices, new technology Main factors influencing investment by firms. Draw a hypothetical investment demand curve, and explain what it shows about the relationship between investment and the interest rate. Discuss the factors.

what are the basic determinants of investment explain relationship

The profit from an investment is equal to the total revenue obtained from it minus the expenses, of which interest is a part. The entrepreneur expects a certain net yield from an investment and if the rate of interest is high the net yield is reduced.

Hence, a high rate of interest will cut out a number of investments and the total volume of investments will be less. Conversely, a low rate of interest will make some investments attractive and the volume of investments will increase. Increase of investment is desirable because it increases income and employment. Keynes, therefore, recommended that central banks should follow cheap money policy, i. This will encourage business people to invest more.

Investment and the Rate of Interest

Moreover, movement in interest rates can also influence investments by providing an indicator of likely future economic conditions. At a fixed point of time, there will exist a range of potential investment projects over the economy, some expected to yield higher rates of return in terms of profitsome lower costs and others possibly a loss.

At the same time, the profitability of marginal investment — what Keynes calls the marginal efficiency of capital — will also decline as Fig. However, it is a matter of great surprise that most study show little connection between investment and rates of interest. Investment appears to be very interest-elastic. A high rate of inflation, when it is anticipated, can have favourable effects on investment.

It is likely to reduce the burden of debt- repayment and make it easier — at least for a time — for firms to widen profit margins following an investment.

However, there is an offsetting consideration. One of the characteristics of high inflation is that it is also likely to be more variable. High and variable inflation is likely to have a damaging effect on investment prospects. The reasons are the following: In order to offset this, firms will require higher returns and will be likely to reject otherwise viable investment opportunities. Investment and changes in consumer demand: This relates the level of planned investment to the rate of change of income and consumer demand for the output of business firms.

If, for instance, the demand for textiles in India increases say, due to a rise in per capita income there will be more demand for textile-producing machines. This is so because the demand for capital goods is a derived indirect demand.

Thus, anything which increases consumption demand, such as per capita income growth or even population growth is always good for industries capital goods producing. Growth of population leads to higher demand for capital. Entrepreneurs get more profit and, therefore, there occurs more investment. Investment and capital stock adjustment: If capital-output ratios are flexible firms would be able to obtain more output from a given capital stock. So, for a given acceleration of output, the larger is the inherited capital stock, the less will be the level of investment required for replacing or adding to existing capacity.

This simply means that at times of low economic activity with low levels of capacity utilisation there will be very weak relation between demand and investment. Empirical studies have shown that the capital stock adjustment theory is quite effective in explaining investment levels.

Investment and debt levels: Confidence Investment is riskier than saving. Firms will only invest if they are confident about future costs, demand and economic prospects. Confidence will be affected by economic growth and interest rates, but also the general economic and political climate.

If there is uncertainty e. Evaluation — Confidence is often driven by economic growth and changes in the rate of economic growth.

It is another factor that makes investment cyclical in nature. Inflation In the long-term, inflation rates can have an influence on investment. High and variable inflation tends to create more uncertainty and confusion, with uncertainties over the cost of investment. If inflation is high and volatile, firms will be uncertain at the final cost of the investment, they may also fear high inflation could lead to economic uncertainty and future downturn.

Countries with a prolonged period of low and stable inflation have often experienced higher rates of investment.

Evaluation — if low inflation is caused by a fall in demand and economic growth — then this low inflation will not, of itself, be sufficient to boost investment. The ideal is low inflationary and sustainable growth. Productivity of capital Long-term changes in technology can influence the attractiveness of investment. In the late nineteenth century, new technology such as Bessemer steel and improved steam engines meant firms had a strong incentive to invest in this new technology because it was much more efficient than previous technology.

If there is a slowdown in the rate of technological progress, firms will cut back investment as there are lower returns on the investment.

what are the basic determinants of investment explain relationship

Availability of finance In the credit crunch ofmany banks were short of liquidity so had to cut back lending.

Banks were very reluctant to lend to firms for investment. Therefore despite record low-interest rates, firms were unable to borrow for investment — despite firms wishing to do that.

Another factor that can influence investment in the long-term is the level of savings. Therefore, investment almost always involves some risk. Consider the following scenario.


You know that your equipment is slow and outdated. You also know that investing in modern computerized printing presses will yield a positive return for your business, but that they will be very expensive. In order to undertake the investment in new equipment, you will have to borrow the money. Should you borrow the money and buy the new equipment?

What will influence you decision? The key variable that will help you to decide whether the investment makes sense for you is the real interest rate that you will have to pay on the loan.

If the expected rate of return in greater than the real interest rate, the investment makes sense.

ECON Macroeconomics

If it is not, then the investment will not be profitable. The real interest rate determines the level of investment, even if you do not have to borrow the money to buy the equipment. The Investment Demand Curve As was illustrated in the example above, the real rate of interest has an impact on determining which investments can be undertaken profitably and which cannot.

The higher the real rate of interest, the fewer investment opportunities will be profitable. This inverse relationship between the real rate of interest and the level of investment is illustrated in the Investment Demand Curve shown below.

As with the Consumption Function, there are factors that will shift the entire Investment Demand Curve. These are non-interest rate determinants of Investment. While there are many things that can influence the level of investment in the economy other than the real interest rate, we will discuss only three. Business Taxes—The government can influence the level of investment by the tax structure they impose on businesses. If the government withdraws these tax incentives, then the Investment Demand Curve shifts to the left.

Changes in Technology—A business will be more likely to increase investment in an industry where technology is changing than in an industry with a more fixed technology.