Investment is the amount spends to add to the stock of capital goods over a given period of time.

It is the most important means of creating employment both directly and indirectly through multiple effects, but at the same time it is the most volatile component of GDP.

Therefore, fluctuations in investment lead to business cycle. During a recession, the investment spending falls while during prosperity it rises.

By the term investment Keynes means real investment and not financial investment. Investment is a function of the real interest rate.


I = I (r) where : r = i – πe

When the real interest rate increases, the investment decreases. Investment is the flow of spending because it adds to the physical stock of capital over a given period of time, whereas capital is a stock because it refers to the given monetary value of all the buildings, machines and inventories at a point of time. The flow of investment is however quite small as compared to the stock of capital.

Forms of investment:

Investment refers to that part of aggregate output for any given time period which takes the form of:


1. New structures.

2. New capital equipment.

3. Change in inventories.

On the basis of this definition of investment, it can be concluded that there are three types of investment spending: (or, people demand capital for following purposes).


1. Business Fixed Investment.

2. Residential Investment.

3. Inventory Investment.

1. Business Fixed Investment:

It is the largest form of investment spending. It is the investment by the firms in goods for use in future production. It includes equipment and structures that business buys to use in production. “Fixed” means that this spending is for capital that will last for a while, but the inventory investment, which will be used or sold shortly later. Firms rely on retained earnings to finance investment.


During recession, share of fixed investment in GDP falls. If the firm’s retained earnings are not sufficient to finance the investment, then it can borrow from outside but if the firms are unable to get funds from outside due to reasons like credit rationing, then the amount of assets they hold will affect their ability to invest.

[Credit rationing occurs when the lender limits the amount which an individual can borrow because of the risk that borrower may become bankrupt and therefore will not be able to repay the amount even though he is willing to do so at the existing interest rates.] The firms are therefore rationed in their access to funding. This problem is more in case of small and medium sized firms than the large firms.

Thus, the firm’s investment decision is affected by:

1. Interest rate: A decrease in the real interest rate lowers the cost of capital. It, therefore, raises the amount of profit from owning capital and increases the incentive to accumulate more capital. Similarly, an increase in the real interest rate raises the cost of capital and leads firms to reduce their investment (↓i→↓ cost of capital →↑ profit →↑ I.)


2. Amount of funds which the firms have saved out of their past earnings and by their current profit.

3. Cost of capital. It is the imputed cost which the firm incurs by investing in plants. If it would had invested in other financial and earning assets then it would have earned an interest. The firm’s investment decision depends on whether owning or renting out capital is profitable. For investment to take place, the earning should be slightly greater than the return from renting out of capital.

Credit Rationing:



When the lender is unable to differentiate between a good borrower and a potential defaulter, he raises the existing interest rates.

Implication of an increase in the interest rate:

On the one hand, the honest customers are prevented from borrowing because they find that at high interest rate it is not profitable to invest;

On the other hand, the dishonest customers will continue to borrow because they have no intention to repay the loan back if their project fails.



Instead of increasing the interest rate, limit the amount of loan lent to the borrower.

The amount of credit given should be rationed according to:

(a) The kind of security the customer offers, and

(b) Future prospects of the economy.

Thus, credit rationing is an important tool of monetary policy to regulate the credit in the economy. If the borrowers perceive that the central bank’s policy of credit rationing and high interest rate will bring recession in the economy, they will borrow less, but if they feel that the bank’s policy will bring boom in the economy, they will borrow more.


Central bank can also impose credit limit on the commercial banks and other lenders by not allowing them to give loans beyond a specified limit. But, such controls may sometimes work, it may even bring recession in the economy. Hence credit controls work in a blunt way and therefore, they cannot be used very often.

Irreversibility and the Timing of Investment Decision:

Capital is putty-putty. It means that goods are in a malleable form. They can be transformed into capital by investment and then easily transformed back into goods. However, much of the capital is putty-clay, that is, irreversible. Once capital is invested, it can be used only for the original purpose and not for any other purpose.

Thus, an irreversible investment will be made only when the firm feels that by waiting there will be no further increase in profitability.

Taxes and Investment:

Tax laws influence firms’ incentive to accumulate capital in many ways:


1. Corporate income tax is a tax on corporate profits. The effect of the tax on investment depends on how the law defines “profit” for the purpose of taxation.

If profit = Rental price of capital (Rp) – cost of capital (C)

Firms will invest if Rp > C

If tax on profit is measured in this way, it will not alter the investment decisions. But there is a difference between the tax Law’s definition of profit and ours.

Under the tax laws: Firms deduct depreciation using historical cost that is, the deduction is based on the price of capital when it was purchased.

e.g. if cost of asset is Rs. 10,000 and if the expected life of asset is 10 years then the asset will depreciate by Rs. 1000 per year.


During inflation, replacement cost which is the cost of buying a new modern machine and replacing it with obsolete capital is greater than historical cost, so the corporate tax understates the cost of depreciation and overstates profit. As a result, the tax law sees a profit and levies a tax even when economic profit is zero, which makes owning capital less attractive. Thus, corporate income-tax discourages investment.

2. Investment tax credit encourages the accumulation of capital. The credit reduces a firm taxes by a certain amount, as a result the effective price of capital reduces.

This raises investment.

Thus, investment tax credit is an effective way to stimulate investment.

2. Residential Investment:

It includes the purchase of new houses either for own use or for earning rent. Housing is an asset because of its long life.

Factors on which the demand for housing depend are:


1. Income level:

When income rises, as housing is a long-term investment, people will invest in housing and thus the demand for housing increases

2. Mortgage interest rates:

An increase in the interest rate will lead to a fall in the demand for housing because mortgage payments are almost entirely comprised of the interest rate.

3. Taxes:

Any change in the tax will affect the demand for housing. For example, Preferential tax treatment for owner occupied houses (where the owner gets some relief from taxes) will increase the demand for housing.

Residential investment depends on the nominal mortgage interest. If the mortgage interest is high, monthly cost of owning the house increases. Therefore, demand for housing increases. Thus, investment in housing will decrease. Also, during recession the demand for residential investment decreases.

Demand for housing stock thus depends on the net real return obtained by owning a house property.

The gross return consists of either:

1. Rent (if the house is rented out)


2. Implicit return which is the imputed value of rent of the house that the owner expects to receive by living in the house, plus the tax benefits on interest payments (if any), and


3. Capital gains arising from increase in value of housing.

Total cost of owning house consists of:

1. Interest cost (mortgage interest rate) : when the property (house) is purchased from borrowed fund

2. Real estate tax

3. Cost incurred on the maintenance of the house, i.e. depreciation

Net Return from house = Gross Return – Total Cost – Tax payments

Net return on housing increases by decreasing interest cost. Therefore, investment in housing increases. The demand for housing thus depends on the relative price of housing which in turn depends on the demand for housing, which depends on the imputed rent. This in turn depends on the wealth, interest available on alternative investment and mortgage interest.

Monetary policy effects housing investment because most of the houses are bought on mortgage. Mortgage is a debt instrument of a very long maturity period, e.g. 20 to 30 years with fixed monthly repayment until maturity. If the monthly repayment is increased, the interest rate will increase.

As a result, the cost of owning a house will rise in proportion to the increase in interest rate. Therefore, demand for housing is very sensitive to the interest rate.

Thus, residential investment is low when mortgage interest are high and high when mortgage interest are low.

Tax treatment of housing/effect of tax and inflation on housing:

Nominal interest payments on a principal residence, that is, the house in which the owner lives, are exempted from tax. Therefore, a combination of high nominal interest rate and inflation encourages housing investment.

But in most cases, high nominal interest rates discourage home ownership because it affects the liquidity in two ways:

1. Homeowners have to make full nominal payment today (present) and receive the offsetting capital gain in future.

2. Banks use rule of thumb to qualify mortgage applicants. (For instance, payments cannot be more than 20% of income). Mortgage interest rate are fixed. They are not adjusted by banks during high inflation.

But if the house-owner gets a subsidy or a tax benefit, then the investment in housing is encouraged.

For instance, landlord lives in his house as a tenant. He deducts mortgage interest while computing his taxable income. During inflation, the nominal interest on mortgage increases, the tax benefits of home ownership rise. Thus, tax benefit encourages investment in housing.

3. Inventory Investment:

Inventories consist of stock of raw materials, stock of unfinished goods and finished goods held by firms in anticipation of products sale. It is the smallest component of spending, averaging about 1% of GDP. During recession, firms stop replenishing their inventory as less goods are sold, and inventory investment becomes negative.

Reasons for holding inventories:

1. Production smoothing:

Inventories help the firm to smoothen their level of production. As it is costly to keep changing the level of output, therefore, producers produce at a relatively steady rate even when demand fluctuates, thus, building up inventories when demand is low. Thus, when sales are low, the firm sells less than what it produces. This inventory is used during periods when sales are high.

2. Stock-out-avoidance:

In periods when demand is more than production and if there are no inventories, the firm will lose sales and profit. Inventories can prevent this from happening.

3. Inventories allow a firm to operate more efficiently:

Manufacturing firms keep inventories of spare parts to reduce the time involved in assembling when a machine breaks.

4. Many goods require a number of steps in production and, therefore, take time to produce. When a product is only partly completed, its components are counted as part of a firm’s inventory. These inventories are called work in process.

5. It is less costly for a firm to order goods less frequently in large quantities than in small quantities frequently.

However, the ratio of inventories to final sales will depend on:

1. Economic variables:

Less is the cost of ordering new goods, greater is the speed with which such goods arrive and the smaller will be the inventory-sales ratio.

2. Level of sales:

The sales inventories ratio decreases when sale increases, because there is uncertainty about sales, as the sale increases.

3. Interest rate:

There is interest cost involved in inventory holding. With an increase in the interest rate, the desired-inventory-sales ratio decreases.

Inventory Investment and the Accelerator Model:

Accelerator Model shows that:

Investment spending is proportional to the changes in the output. It is not affected by the cost of capital.

I = α(Y-Yt)

Greater the change in output, greater will be the change in inventory.

Y > Yt → I will increase

Y < Yt → I will decrease

Types of Inventories:

1. Anticipated/Planned/Desired Inventory Investment:

Inventory investment will be high if the firms plan to build up its inventories. It adds to the aggregate demand.

2. Unanticipated Inventory Investment:

When sales are unexpectedly low, unsold inventories will increase. This is due to unexpectedly low AD.

Role of business cycle in inventories:

Inventory investment fluctuates proportionately more during business cycle.


AD falls; inventories increase; thus inventory – sales ratio increases.


Firm decreases production, the demand is met by selling the inventories. Thus at the end of recession inventories will decrease.

Thus, a combination of anticipated and unanticipated inventory changes, influence the role of inventories in the business cycle.

‘Just-In-Time’ Inventory Management:

If inventories are kept in line with AD, fluctuations in inventory investment can be reduced.

‘Just-in-time’ inventory management is a technique imported from Japan. According to this technique, the firms should operate with small inventories by synchronization of the procedure between the suppliers and the users of the material.

Investment and Aggregate Supply (AS):

In Short run: Investment does not affect the AS

In Long run: Investment affects the AS.

It is an important tool for creating long-term prosperity.

Investment around the World:

High growth countries experience a high growth rate because they devote a substantial fraction of their output for investment.