Investment Function | UGC NET Economics – Notes

Introduction

• Investment is considered a critical variable in macro-economic models. The significance of the investment function runs through the entire macro-economic literature. In classical theory, in Keynesian macro-economic models as well as in the business cycle theories and economic growth models, the investment function figures prominently. Thus Ackley says: “Investment has been assigned a position of cruicial importance in almost all macro-economic theories. This is true not only of modern Keynesian and post-Keynesian theories but as well of most earlier business cycle theories.”

• In the ever growing economic literature on underdeveloped economies, the investment function is given great prominence. While from a theoretical point of view the significance of investment function in macro-economic studies is beyond all doubt, some authors like Colin Clark pointed out to the too much pre-occupation with investment in the post-war concern about economic growth. Colin Clark says that “in recent years all the emphasis in the discussion of growth has been concentrated on one of the factors concerned namely investment.”

• According to Colin Clark that much of the concern about investment function as a crucial factor in any economy has developed “in the years immediately following 1945, when the outstanding problem for most countries was shortage of capital equipment and stocks as a result of war.” He contends that investment while essential, is not the only crucial factor for economic growth. Although he shows some statistical evidence in support of his arguments, he seems to have based his arguments in what he says that “Economists are not yet in a position to analyse this matter fully.”

• Not going into the details of the controversy whether investment is crucial or not for economic growth, it can certainly be maintained that investment is one of the most important variables of any economic system. For example, Keynes maintains “that employment can only increase pari passu with investment”. He further goes on to say that in an extreme case where “the marginal propensity to consume is not much above zero, small fluctuations in investment will lead to correspondingly small fluctuation in employment; but, at the same time, it may require a large increment of investment to produce full employment.”

• The importance of the investment function gets magnified when it is recognised that this is also the most volatile variable in any economic system. Thus Haavelmo observes: “Since investment is an important part of total economic activity, variations in the rate of investment would naturally affect other variables such as consumption, employment, wages etc. The result could be cyclical in various ways.” Problems of economic growth and the behaviour of any economy can be more thoroughly explained when once the economists succeed to build a comprehensive theory of investment function.

• Thus while there is due recognition of the importance of investment function, still the present stage of investment theory falls far short of the real world requirements. Thus Haavelmo remarks: “Economic theory can give a reasonably good account of how the level of investment activity influences effective demand and employment, if only we knew more about the determinants of investment.” Despite the fact that several economists devoted great attention to theoretical model building and a large number of empirical studies were carried out with respect to investment function, it still remains an economic riddle to be solved. As Meyer and Kuh observe that “of the various domains of economics, one of the most confused and controversial has been the theory of the demand for assets.”

• As mentioned earlier investment function transcends into several areas of macro-economic theory. Particularly on the subject of investment function in addition to several theories and theoretical discussions, there are a large number of empirical studies. While some of these latter type of studies attempted to test the various theories, other studies could lead to modifications of the theories and still other studies attempted to explain investment with an integrated approach.

• In view of such a broad scope of the subject this paper will make an attempt to critically consider some of the important theories of investment function. According to Haavelmo, investment theories can be subdivided into:

  1. “theories of the effects of rate of investment,

  2.  theories of the determinants of the level of investment activity and

  3. theories of the determinants of variations in this level.” 

• However, this paper will be mainly confined to the latter two types of theories which explain the investment process and the determinants of investment in an economy. While a complete survey of all the empirical studies is beyond the scope of this paper, the empirical evidence pertaining to each theory will be considered generally. Some of the important recent approaches to the theory of investment function will also be reviewed. Finally it will be attempted to bring out some thoughts on the complex nature of investment function.