INTRODUCTION

• National income and employment in the short run depend on the level of aggregate demand.
• Aggregate demand in Keynes’s two-sector model consists of consumption demand and investment demand.
• The consumption function is generally stable in the short run, while investment demand plays a crucial role in determining income and employment.
• The higher the level of investment, the higher the level of income and employment.
• According to Keynes, the equilibrium in a capitalist economy is usually not at the level of full employment because investment demand is insufficient to match the savings at the full-employment income level.
• Underemployment equilibrium arises due to insufficient investment demand compared to savings at the full-employment level, leading to a deflationary gap in the economy.
• The deflationary gap results in a rise in the general price level.
• Investment demand is key to determining national income, employment, and prices in an economy.
• Investment refers to the creation of new capital assets, such as machines, factories, and physical capital.
• Buying existing shares or bonds is termed financial investment, not the real investment that impacts income and employment.
• Real investment involves the creation of new physical capital, such as plants, machines, and buildings, which creates income and employment.
• Investment in economics means the expenditure on adding to the stock of capital goods like machines, buildings, tools, etc.
• Net investment, the addition to the stock of physical capital, increases aggregate demand, leading to higher income and employment.
• Keynes and other economists also consider the increase in inventories of consumer goods as part of investment in the country.

TYPES OF INVESTMENT

Distinction must be drawn between the following three types of investment:

1. Business fixed investment
2. Residential investment
3. Inventory investment

Business Fixed Investment

• Business fixed investment refers to investment in machines, tools, and equipment used in the further production of goods and services.
• The stock of these machines, tools, and equipment represents fixed capital.
• The term ‘fixed’ implies that expenditure on these items continues to be used for production over a relatively long period.
• This is different from inventory investment, which involves items used or sold shortly for production.
• Business fixed investment is important as a component of aggregate demand, playing a significant role in determining national income and employment.
• It is a volatile component of aggregate demand, and fluctuations in business fixed investment are responsible for business cycles in a free-market economy, as emphasized by Keynes.
• Keynes’s theory of investment suggests that business fixed investment is determined by the expected rate of profit(also called marginal efficiency of capital) and the rate of interest.
• In the short run, the rate of interest is relatively sticky, and changes in expectations about future profits lead to fluctuations in business fixed investment.
• According to neoclassical theory, business fixed investment is determined by the marginal product of capital and the user’s cost of capital.
• User’s cost of capital depends on the price of capital goods, the interest rate, and the depreciation rate.
• If the marginal product of capital exceeds the user’s cost of capital, firms will find it profitable to undertake fixed investment.
• In the neoclassical model, the rate of interest and taxation of profits play a crucial role in determining business fixed investment.