Investment is the commitment of money or capital to purchase financial instruments or

other assets in order to gain profitable returns in the form of interest, income, or
appreciation of the value of the instrument. It is related to saving or deferring
consumption. Investment is involved in many areas of the economy, such as business
management and finance no matter for households, firms, or governments. An investment
involves the choice by an individual or an organization such as a pension fund, after some
analysis or thought, to place or lend money in a vehicle, instrument or asset, such as
property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the
foreign asset denominated in foreign currency, that has certain level of risk and provides
the possibility of generating returns over a period of time.

Investment comes with the risk of the loss of the principal sum. The investment that has
not been thoroughly analyzed can be highly risky with respect to the investment owner
because the possibility of losing money is not within the owner's control. The difference
between speculation and investment can be subtle. It depends on the investment owner's
mind whether the purpose is for lending the resource to someone else for economic
purpose or not.

In the case of investment, rather than store the good produced or its money equivalent,
the investor chooses to use that good either to create a durable consumer or producer
good, or to lend the original saved good to another in exchange for either interest or a
share of the profits. In the first case, the individual creates durable consumer goods,
hoping the services from the good will make his life better. In the second, the individual
becomes an entrepreneur using the resource to produce goods and services for others in
the hope of a profitable sale. The third case describes a lender, and the fourth describes an
investor in a share of the business. In each case, the consumer obtains a durable asset or
investment, and accounts for that asset by recording an equivalent liability. As time
passes, and both prices and interest rates change, the value of the asset and liability also
change.

An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of

getting a future return or interest from it. The word originates in the Latin "vestis",
meaning garment, and refers to the act of putting things (money or other claims to
resources) into others' pockets.. The basic meaning of the term being an asset held to
have some recurring or capital gains. It is an asset that is expected to give returns without
any work on the asset per se. The term "investment" is used differently in economics and
in finance. Economists refer to a real investment (such as a machine or a house), while
financial economists refer to a financial asset, such as money that is put into a bank or the
market, which may then be used to buy a real asset.
In economics or macroeconomics

In economic theory or in macroeconomics, investment is the amount purchased per unit

time of goods which are not consumed but are to be used for future production. Examples
include railroad or factory construction. Investment in human capital includes costs of
additional schooling or on-the-job training. Inventory investment refers to the
accumulation of goods inventories; it can be positive or negative, and it can be intended
or unintended. In measures of national income and output, gross investment (represented
by the variable I) is also a component of Gross domestic product (GDP), given in the
formula GDP = C + I + G + NX, where C is consumption, G is government spending, and
NX is net exports. Thus investment is everything that remains of total expenditure after
consumption, government spending, and net exports are subtracted (i.e. I = GDP - C - G -
NX).

Non-residential fixed investment (such as new factories) and residential investment (new
houses) combine with inventory investment to make up I. Net investment deducts
depreciation from gross investment. Net fixed investment is the value of the net increase
in the capital stock per year.

Fixed investment, as expenditure over a period of time ("per year"), is not capital. The
time dimension of investment makes it a flow. By contrast, capital is a stock— that is,
accumulated net investment to a point in time (such as December 31).

Investment is often modeled as a function of Income and Interest rates, given by the
relation I = f(Y, r). An increase in income encourages higher investment, whereas a
higher interest rate may discourage investment as it becomes more costly to borrow
money. Even if a firm chooses to use its own funds in an investment, the interest rate
represents an opportunity cost of investing those funds rather than lending out that
amount of money for interest.

Factors that determine levels of investment in the

economy
Saving and Investment.

There is an important economic idea that Savings = Investment. The logic is that without
bank deposits, banks are not in a position to lend money for investment.

An economy with a low savings ratio has little funds to finance investment because it is
all being used to finance current consumer spending.
However, higher levels of saving do not necessarily lead to more investment. The extra
saving may not encourage people to invest more. E.g. In the great depression, individual
savings did not encourage investment. Keynes called this the paradox of thrift

Keynes said that an important factor in determining investment was, not so much levels
of savings, but peoples attitude to the future of the economy.

This is perhaps why full employment is important. In a recession, extra savings may just
be saved and not used to finance resources. However, when the economy is close to full
employment, extra savings are important for financing extra investment.

Another factor is financing investment from abroad.

UK has a current account deficit but, the UK has also been able to attract capital
investment from abroad e.g. Japanese firms investing in the UK.

The movement of interest rates

is of course one of the most fundamental factors affecting investment
decisions. If rates go up, then the currency becomes more attractive to hold
relative to another, as the returns on holding the currency is greater. On the
other hand, a rise in interest rates is unfriendly for real investments as it
means that as an option, borrowing money becomes more expensive, and
consumers will have less disposable income. Similarly, if rates decrease then it
means that financing for a business becomes less expensive, and this will
encourage business activity.

From the consumer’s perspective, lower interest rates means that mortgages,
and other consumer loans become cheaper. Consumers will take advantage of
the less expensive money to improve their life styles by buying new houses and
motor vehicles.

The fact is that even if interest rates were to be reduced by 5%, there would
still be limited uptake in corresponding investments. The reason for this is that
investment decisions are affected by much more than interest rates, and other
monetary policy. We have to remember that economics is a social science, and
consequently is a study of the behaviour of people. When we change monetary
policy to influence economic outcomes, what we are hoping to do is influence
the behaviour of individuals. So reducing interest rates does not by itself
improve economic performance.

When interest rates are reduced, it is expected to have the result of affecting
people’s investment decisions, as it is hoped that an individual will want to
borrow money at the lower cost and invest it in real businesses, which gives a
higher return than the cost of the funds borrowed. And this is what happens in
countries such as the US and UK. The reason why a rate reduction will have the
intended effect therefore is because individuals will react in the desired way.
What we need to ascertain then is what is it that influences this reaction from
individuals?

In the US, for example, when the Fed wants consumers to increase economic
activity and drive new investments they will lower interest rates. Lower rates
will mean reduced funding costs for businesses and consumer purchases. Thus
demand for debt financing will increase. When these funds are accessed then
individuals will look at the investment options available and invest in ventures
that will give them a consistently higher return than the cost of the borrowed
funds. Lower rates will also cause the currency to devalue
The marginal efficiency of capitalagainst that of major trading partners (assuming
their rates do not change), resulting in the relative price of goods produced
being cheaper, thus increasing exports.

The marginal efficiency of capital

. Annual percentage yield earned by the last additional unit of capital. It is also known as
marginal productivity of capital, natural interest rate, net capital productivity, and rate
of return over cost.

The decision to invest in a new capital asset depends on wether the expected rate of
return on the new investment is equal to or greater or less than the rate of interest to be
paid on the funds needed to purchase this asset The significance of the concept to a
business firm is that it represents the market rate of interest at which it begins to pay to
undertake a capital investment. If the market rate is 10%, for example, it would not pay to
undertake a project that has a return of 91⁄2%, but any return over 10% would be
acceptable. In a larger economic sense, marginal efficiency of capital influences long-
term interest rates. This occurs because of the law of diminishing returns as it applies to
the yield on capital. As the highest yielding projects are exhausted, available capital
moves into lower yielding projects and interest rates decline. As market rates fall,
investors are able to justify projects that were previously uneconomical. This process is
called diminishing marginal productivity or declining marginal efficiency of capital.

Annual percentage yield earned by the last additional unit of capital; also known as
marginal productivity of capital, natural interest rate, net capital productivity, and rate of
return over cost. The significance of the concept to a business firm is that projects whose
marginal efficiency of capital exceeds the market rate of interest are profitable to
undertake.
Accelerator principle
The accelerator principle defines the growth in output that would induce a continuation
in net investment. In other terms, net investment is a function of the alteration in output.
The accelerator principle has played an important role in defining the fluctuations in
investment, which is an integral part of business cycle theories that are still used today.

The accelerator principle often assumes that the ratio of capital to output is retained at a
constant level.

The accelerator principle says that small changes in consumer spending can cause big
percentage changes in investment. It played a role in many business-cycle theories and is
still used today to explain some of the fluctuation in investment.

In a very simple form the accelerator principle assumes that the ratio of capital to output
tends to remain constant. Suppose, for example, that normally it takes $1000 worth of
equipment to manufacture $1000 worth of shoes each year. Suppose further that each
year one tenth of the equipment wears out. If there is no growth or decline, total
investment each year will be $100, all for replacement.

Now suppose that the sales of shoes jumps by 5%, to $1050 each year. The new desired
amount of equipment will also rise by 5%, to $1050. However, to obtain this new level,
investment will have to increase by 50%, to $150. Thus if firms desire a constant capital-
to-output ratio, a small percentage change (either an increase or decrease) in final sales
can lead to a big percentage change in investment.

Looking at another example, if a commercial entity producing leather bags invests $1,000
worth of equipment to produce $1,000 worth of products annually, and each year one
tenth of its equipment wears out, the total investment for replacement would be $100
assuming that there is no growth or decline. In such a case, if the sale of leather bags
increases by 5% to $1,050 annually, the amount of equipment will also rise by 5% to
$1050. However, the total investment will increase by 50% to $150 to achieve the desired
level. Consequently, it can be said that the companies desire to achieve constant capital-
to-output ratio, a marginal percentage change in the sale of products can result to a higher
percentage change in investment.

The accelerator effect in economics refers to a positive effect on private fixed

investment of the growth of the market economy (measured e.g. by a change in Gross
National Product). Rising GNP (an economic boom or prosperity) implies that businesses
in general see rising profits, increased sales and cash flow, and greater use of existing
capacity. This usually implies that profit expectations and business confidence rise,
encouraging businesses to build more factories and other buildings and to install more
machinery. (This expenditure is called fixed investment.) This may lead to further
growth of the economy through the stimulation of consumer incomes and purchases, i.e.,
via the multiplier effect.
The accelerator effect also goes the other way: falling GNP (a recession) hurts business
profits, sales, cash flow, use of capacity and expectations. This in turn discourages fixed
investment, worsening a recession by the multiplier effect.

The accelerator effect fits the behavior of an economy best when either the economy is
moving away from full employment or when it is already below that level of production.
This is because high levels of aggregate demand hit against the limits set by the existing
labor force, the existing stock of capital goods, the availability of natural resources, and
the technical ability of an economy to convert inputs into products.