- Large public investment may crowd out private investment.
- It can raise the rate of interest, discouraging private investors.
- Public investment may reduce marginal efficiency of private capital by increasing production costs.
- It can also create unfavourable expectations among entrepreneurs, lowering private investment.
Definitions [1]
Definitions: Investment
- "Investment refers to the increment of capital equipment." — J.M. Keynes
- "By investment we do not mean the purchase of existing paper securities, bonds, debentures or equities, but the purchase of new factories, machines and the like". — Stonier and Hague
- "Investment expenditure includes expenditure for producer’s durable equipment, new construction and the change in inventories." — Peterson
Formulae [2]
Formula: Propensity to Invest
PI = `I / Y`
PI = Propensity to invest, I = Aggregate Investment, Y = Aggregate Income
Formula: Investment Function
The relationship between investment and the rate of interest can be written as:
I = f(r)
Here:
- I = Investment, the planned amount of investment; it is the dependent variable.
- r = Rate of interest; it is the independent variable that influences investment.
This notation means that the level of investment depends on the rate of interest.
Key Points
Key Points: Investment
- Economic investment = addition to physical capital + change in inventories — NOT buying shares/bonds
- Autonomous investment is income-inelastic, welfare-driven, mostly by government; drawn as a horizontal line
- Induced investment is income-elastic, profit-driven, mostly private; drawn as an upward-sloping line
- Gross Investment = Net Investment + Depreciation; net investment positive means capital accumulation
- Ex-ante = planned; Ex-post = actual; equilibrium requires ex-ante S = ex-ante I
- Investment function I = f(r) is downward-sloping — higher interest means less investment
- Invest when MEI > Rate of Interest; stop when MEI = Rate of Interest
Key Points: Determinants of Induced Investment
- Marginal Efficiency of Capital (MEC): Expected rate of profit on new investment; depends on entrepreneurs’ expectations, optimism, and business outlook.
- Rate of Interest (ROI): Cost of borrowing; higher ROI discourages investment, lower ROI encourages it.
- Investment decision rule: Investment increases when MEC > ROI, stops when MEC = ROI.
- Keynes emphasized that changes in MEC, rather than interest rate alone, play a major role in affecting investment and employment.
Key Points: Measures to Stimulate Private Investment
- Tax concessions on profits increase MEC and encourage investment.
- Lower rate of interest may stimulate investment, though Keynes stressed limited responsiveness.
- Government spending (pump-priming) boosts income and induces private investment through the multiplier.
- Price stability and price support policies reduce uncertainty and promote investment.
- Research, innovation, and competition (reducing monopoly power) open new investment opportunities.
Key Points: Importance of Investment
- Investment is the key driver of income, output, and employment in an economy.
- Through the multiplier effect, an increase in investment leads to a multiple increase in income.
- Investment promotes capital formation, raising productive capacity and economic growth.
- It helps reduce unemployment and depression and ensures long-term prosperity.
Key Points: Source of Public Investment
- Taxation: Raises funds but merely transfers purchasing power; limited use recommended.
- Public borrowing: Better than taxation; uses idle savings through bank and private loans, though it creates a debt burden.
- Deficit financing: Creation of new money to fund investment; supported by Keynes to cure unemployment, but may cause inflation after full employment.
Key Points: Dangers of Public Investment
